Betting on Fed Interest Rate Decisions

August 8, 2019

Source: Bloomberg Source: Bloomberg

The current U.S. economic expansion is officially the longest in U.S. history, having reached 121 months in July and still counting. Meanwhile, on July 31, the Federal Reserve (Fed) announced its latest interest rate decision, cutting the Fed funds rate by 0.25% — the first cut in over a decade.

This decision might surprise some people since the U.S. economy is still growing at a healthy rate. The Fed attributed its action to slowing global growth, trade policy uncertainties and stubbornly low inflation. However, the derivative market had already seen it coming. One type of derivative, called Fed funds futures, allows traders to express their views on where the Fed funds rate will land each future month out to 36 months. The contract is cash settled on the average Fed funds rate of the last month before its expiration. Since the Fed funds rate can only be materially moved by the central bank’s decision, the difference between the futures price and the current Fed funds rate signals market expectations for the Fed’s interest rate decisions.

For example, on July 24 (a week before the cut), the difference was 0.29%. It indicated that most traders believed the Fed would cut interest rates by 0.25%, with a small group of traders favoring a cut of 0.50%. By incorporating a small amount of math, probabilities can also be assigned to different outcomes. The futures prices are decided by pulling and pushing from all the different traders until an equilibrium is reached. The better the liquidity, the more credible the information conveyed by the price. As the chart of the week shows, from 2015 (when the Fed started hiking interest rates) to the recent cut, the futures market has been pretty reliable in forecasting interest rate decisions shortly before their release.

There are several reasons for this predictability. First, in the financial markets, people are facing real money gain and loss. Every Fed interest rate decision has a profound impact, so anticipating the central bank’s next move is truly financially incentivized. Second, the Fed has been continuously transparent with the public. Clear communication makes the guessing game much easier. Finally, the Fed pays close attention to the financial market. Deviating away from market consensus could potentially cause market turbulence.

Based on the futures prices as of Aug. 5, the market is expecting another interest rate cut in September, with the potential for more by year-end. However, in the press conference after the July cut, Fed Chair Jerome Powell did not promise any further interest rate cuts. Will the market alter its expectations? Time will tell. There is still enough time for the two to converge.


Key Takeaway

Historically, Fed funds futures have done a pretty good job of predicting Fed interest rate decisions. Although a “looking-in-the-mirror” Fed would not help its credibility, the gravity between the Fed and financial markets has been important for financial stability. If you want to bet on the Fed’s interest rate decisions, don’t get distracted by its pirouettes. Look to Fed funds futures for odds.

Tags: Interest Rates | derivative market | futures market | Federal Reserve | Federal Funds Rate

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