By Ben Eisen, MarketWatch
Fed funds futures, the interest-rate contracts that give Wall Street traders an outlet for betting on rate hikes, are back in action as the Federal Reserve moves to reverse policy that's kept rates near 0% for nearly five years.
The December fed funds futures 2014 contract (FFZ4) traded on the CME Group's (CME) Chicago Board of Trade implied a fed funds rate of 0.44% Friday morning. That's slightly lower than it had been before a disappointing nonfarm payrolls report, but it's still up markedly from 0.18% on May 1 and 0.31% on August 1, according to FactSet.
Speculation on the Fed's benchmark policy rate, for years the main policy tool to add liquidity and jump-start lending, never went away in the years since 2008 when the central bank reduced the rate to an unprecedented 0% to 0.25% and said it would keep the target there for some time. But betting on rate hikes or rate cuts lost their verve as the central bank under Fed Chief Ben Bernanke pulled the central bank into a new era: quantitative easing, or the $85 billion in monthly bond purchases that also force down real interest rates.
As the Fed signaled in May that it could begin the so-called tapering process this year, pushing up Treasury yields sharply over the past four months, the pricing on fed funds futures contracts has shown increased expectations for higher rates.
The June 2015 (FFM5) contract prices in an implied fed funds rate of 0.830%, up from 0.280% back on May 1 and 0.690% on the last trading day in August, according to FactSet. And an August 2016 fed futures contract (FFQ6), the longest-dated contract currently listed, prices in an implied fed funds rate of 2.110%. The effective fed funds rate is 0.09% as of Friday.
Fed funds are the rate at which depository institutions lend to each other overnight, and the contracts allow investors to place money on when those benchmark rates will change. Bank treasurers and bond fund managers also use them to hedge rate-sensitive investments.
With the Fed committed to holding the fed funds target rate low until the unemployment rate hits 6.5%, no imminent changes to the policy rate are expected. Nonetheless, futures contracts are pricing in rate hikes as soon as 2014, even as expectations of reaching the unemployment threshold focus on a more distant 2015 time-frame.
"I think the market was having a hard time figuring out what the sequencing and timing would be," said Robert Tipp, chief investment strategist at Prudential Fixed Income.
Reading into fed funds futures as an indication of rate expectations has its downsides. For one, trading tends to be relatively illiquid, particularly at the further reaches of the curve. Given low volume, the fact that many traders use fed futures as a hedge against other markets may obscure further its predictive power.
From the archives: Fed funds futures' murky outlook (March 2010)
The Eurodollar futures contract, which projects the interest rate for dollar deposits outside the U.S., provides a more liquid approximation of Fed funds futures based on Libor. And that indicator shows an even more aggressive rate of 0.76% on the December 2014 contract (EDZ4).
Moving further out on the time spectrum, the June 2015 eurodollar futures contract (EDM5) prices in a rate of 1.20%.
The more aggressive pricing of rate expectations has baffled even some of the bond market's more seasoned veterans. Pimco's Bill Gross noted his dismay at the move in fed futures on Tuesday via Twitter, particularly surprising given the asset manager's expectations that the policy rate will be held at its current levels through 2016. Yields at the front-end of the Treasury curve are correspondingly too high, Gross said through Twitter Friday.
To the extent that fed funds futures accurately measure expectations of the Fed's policy rate -- unscathed by talk of "taper" or other factors impacting the prices of Treasurys -- the move in expectations signals real fears in the markets beyond the imminent withdrawal of monetary stimulus, some say.
One of those fears has to do the with the trajectory of the policy rate if the Fed chairmanship post goes to Larry Summers, the former U.S. Treasury Secretary who many see as the favored candidate, said Tom Tucci, managing director and head of Treasury trading at CIBC World Markets Corp, in a note. Summers is seen as competing against Fed vice chairman Janet Yellen for appointment as Fed chair when Bernanke likely leaves office in January.
"I am thinking this may be the indirect consequence of growing expectations that Larry Summers will be the next Fed Chairman. The current Fed put in forward guidance with a 6.5% unemployment rate which most anticipate will occur in 2015. That was with Bernanke at the helm," Tucci said. "There is no guarantee that a regime under a new Chairman would hold to that guidance and there is also a large turnover of the voting Board members."
However, he added that the disappointing payrolls number Friday may help easing the aggressive pricing of Fed rate hikes.
At the Fed's policy meeting in two weeks, in which it is largely expected to announce a plan to begin curbing asset purchases, the central bank could signal its forward guidance further out on the time spectrum. That may help settle -- or unsettle -- the markets, said Tipp, of Prudential.
"If the Fed comes in at this meeting and shows a higher pace of rate hikes than expected, that would be very bad for the market," he said.
One other factor that could add a dose of uncertainty to the fed funds futures market in the coming years: possible changes to market mechanics that unseat the fed funds rate as the central policy rate. If the Fed were to move toward using the rate of interest on excess reserves as the primary rate, that could change the nature of liquidity in the fed funds rate.
"The Fed has generally communicated fed funds rate but the ability to continue to do that in the future is not certain. It could be the case that fed funds rate plays a less central role in the future than it does now," said Zach Pandl, senior interest-rate strategist at Columbia Management.
-Ben Eisen; 415-439-6400; AskNewswires@dowjones.com
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(END) Dow Jones Newswires
09-06-13 1257ETCopyright (c) 2013 Dow Jones & Company, Inc.
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