One of the most closely-watched and widely reported on economic events on the financial calendar is the Federal Open Market Committee (FOMC) decision on the Fed Funds Target Rate that happen at Federal Reserve meetings eight times per year. This target rate impacts the interest rates consumers pay on almost all loans including credit cards, mortgages and bank loans.
How does it work?
Contrary to popular belief, the Federal Reserve no longer sets a specific interest rate at FOMC meetings. Rather, since December 2008 it has set a range between which it aims to keep the interest rate that Banks and other Depository institutions lend money to each other on an overnight basis. This interest rate is known as the effective federal funds rate (EFFR) or “Fed Effective Rate”. So, when you hear, for example, that the FOMC has decided to “raise interest rates by 25 basis points”, what it has really done is increased the target range by 25 basis points. For example, on December, 19, 2018, it raised the target range from 200-225 basis points to 225–250 basis points (a basis point is equal to .01% so the target rate would be 2.25%-2.50%).
While the Federal Reserve does not “set” specific interest rates, it has several tools at its disposal to help ensure that the EFFR falls within its target range. The most relied upon tool is called “Open Market Operations”. Essentially, the Fed can influence the rate at which banks loan money to one another by buying and selling treasury securities from and to primary dealers, thus increasing or decreasing the level of liquidity in the financial system.
CME Group Fed Funds Futures
CME Group lists 36 monthly Fed Funds futures contract expiries on its central match engine, Globex. Contracts in the first 12 months typically represent the market view of FOMC policy. These allow market participants to hedge existing risks associated with changes to the Fed Funds rate or take a speculative view of upcoming FOMC action. Contracts in the subsequent 2 years can be used to hedge long-term funding requirements.
CME Group Fed Funds futures settle at the end of each month based on 100 minus the arithmetic average (mean) of each day’s EFFR of the contract month. EFFR rates are assigned to every day in a month including weekends and holidays based on the rate assigned to the previous business day. For example, the rate assigned to a Saturday and Sunday will be the same rate that was published for the Friday prior to the weekend (assuming Friday was not a holiday). The arithmetic mean is calculated including all days in a month such that the denominator in the calculation is always the actual number of days in the month. At any given time, the quoted price of Fed Funds futures is the market consensus of what the daily average of the EFFR will be at the end of the month. The New York Fed publishes the daily EFFR at approximately 9:00 AM Eastern time for the prior day.
In other words, halfway through each month, the “market” already has half of the daily inputs that will go into the month end settlement. Therefore, the current price will reflect the average up until that day, which will be 50% of the average plus the market expectation of the average over the second half of the month. If there are no scheduled FOMC meetings remaining in a given month, one would expect the price to fall within the Federal Reserve’s target range unless there was an expectation of an intrameeting rate move which historically only happens during times of great volatility.
A real-life example
Recent CPI and PPI readings, which have been higher than we’ve seen in decades, have resulted in heightened expectations of an FOMC target rate hike. The last time that the Federal Reserve raised its target rate was in December, 2018, so we’ve used prices from that month to demonstrate how CME Group Fed Funds futures can be used to hedge risks or express an opinion on whether, and by how much, the FOMC might change the target rate.
At the beginning of December 2018, the Fed’s Fed Funds target rate was 2.00-2.25%. This is consistent with the EFFR of 2.19-2.20% (as shown by the gray line above). The market expectation at the beginning of the month was that the FOMC would raise its target rate by 25 basis points at the December 19th meeting.
Remember, the December 2018 futures contract settles to the arithmetic mean of the EFFR for the entire month of December.
Therefore, given that there was overwhelming sentiment that the Fed would raise its target rate by 25 basis points on December 19 (just over halfway through the month), one could reasonably expect that the Dec Fed Funds futures price would imply a rate between the target rate at the start of the month and the anticipated target rate after the December 19th meeting. Indeed, as you can see in the blue line in the graph above, the futures implied rate was between the EFFR from 12/1-12/19 and from 12/20-12/31.
The January Fed Funds futures implied rate also sheds light on the market expectation for FOMC action in December 2018 and January 2019. As the green line in the graph shows, the January 2019 Fed Funds futures implied rate is between 2.35 and 2.40 throughout the month of December 2018. This reflects the expectation that the arithmetic average of the EFFR in January 2019 would be in that range. In other words, the implied rate of the January Fed Funds futures suggests that the Fed Funds target range (and EFFR) would be between 2.25 and 2.50 throughout the month of January, which would make sense if the FOMC raised rates in December but not in January.
Another way to look at it
As we’ve stated, the Fed Funds futures contract will settle to the arithmetic mean of the EFFR at the end of each month. Therefore, each day that passes in a given month provides another of the 28, 30 or 31 (depending on the number of days in a month) data points that will be used to calculate the average EFFR for that month. In our example, the arithmetic mean of the EFFR for December, 2019 was ~2.275, which, incidentally, was the futures price on the last day of the month. In hindsight, we can simply average the EFFR for each day of the month. However, a different way to arrive at that number is to weight the EFFR before and after the December 19th rate hike: Average EFFR (12/1-12/19): 2.195
Average EFFR (12/20-12/31): 2.4
Because there are 19 days before the rate hike and 12 days after the rate hike:
Weighted Average = 2.195*(19/31) + 2.4*(12/31) = ~2.275
Which is close to the level at which the December Fed Funds futures traded throughout the month.
At the time of this writing, in February 2022, there is market consensus that the FOMC will raise its Fed Funds target rate throughout 2022. Fed Funds futures contracts offer a view into the market expectation of the number and magnitude of rate hikes as well as the ability to assume a position based on one’s own view of the interest rate landscape.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.