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.
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 “cut interest rates by 25 basis points”, what it has really done is reduced the target range by 25 basis points. For example, on October 30, it reduced the target range from 175-200 basis points to 150-175 basis points (a basis point is equal to .01% so the target rate would be 1.5%-1.75%).
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 lists 36 monthly Fed Funds futures contracts 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 monthend 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 intra-meeting rate move which historically only happens during times of great volatility.
The table below shows the October Fed Funds futures prices as well as the actual effective rate for the month of October 2019. The Fed Funds Target range at the beginning of October was 1.75-2.00% and there was a market consensus that the FOMC would cut the range to 1.50-1.75% at the meeting on October 30.
|Date||October Contract Settlement Price||October Contract Rate||EFFR (red is assigned)||Average EFFR to date||November Contract Settlement Price||November Contract rate|
As you can see, both the EFFR and the October futures price from October 1 through October 30 were within the Fed target range of 1.75%-2.00% (it was in fact between 1.80% and 1.90%). However, on Oct. 31, the day after the FOMC lowered Fed Funds target to 1.50-1.75%, the EFFR dropped to 1.58%.
So why didn’t the October futures price also drop on October 31? Remember, the October futures settle to the average of the daily EFFR for the month of October. So, the one day (October 31) on which the EFFR declined after the rate cut is only 1/31st of the futures monthly settlement. In other words, the October futures settlement is going to be overwhelmingly weighted towards the price level on the other 30 days when the target rate was between 1.75-2.00 and actual rates were in the range 1.82% and 1.90%.
Using this same period as an example provides a good case study in how one can use Fed Funds futures to express a trading view on the FOMC decision because the meeting in October happened on the last day of the month and there was no scheduled meeting in November. Therefore, the November contract, not the October contract, provides a relatively pure way to trade the October 30 decision.
As you can see, throughout the month of October, the price of the November futures contract is consistently within the 1.50-1.75% range (if we take 100 minus the price). This makes intuitive sense given market was pricing a probable cut by the Fed rates on October 30. While the October contract traded in the narrow range of 1.82-1.86% throughout the month the November contract moved lower in rate terms (higher in price) from 1.705% to 1.5875%. This indicates that through the month of October the market was increasing the price probability of the Fed’s expected rate cut. The move of approximately 12bps can be interpreted as an increased probability of 48% for a 25bp cut (12bp/25bp = 48%).
If you had formed the strong view at the beginning of October that the Fed would cut rates you could have bought.
Alternatively you had a view of the FOMC action at the October 30 meeting and thought they would either hold interest rates steady or even raise the target range, you might sell the November Fed Funds futures contract. If the FOMC then did hold rates steady, you’d expect the price of the November contract to decline (interest rate rise) at least to 98.25 (within the 1.75-2.00 range) from the 98.4125 level at which it actually traded that day.
Each basis point move in the Fed Funds futures contract represents a dollar value of $41.67 per contract. A move from 98.4125 to 98.25 would represent a $677.14 (16.25 basis points). In general, a price move representing a typical FOMC move of 25 basis points would be worth $1041.75, though typically the market does not move by a full 25bp in one go as the dynamic repricing of expectations likely makes the moves smaller. Keep in mind, there is no guarantee that the EFFR will fall within the Federal Reserve’s target range, though the institution has historically been quite effective in achieving that.
CME Group’s Fed Funds futures contract can be a very effective way to express a view on FOMC policy action from the present through the next 12 months.
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