The previous article gave a background about the fed funds futures rate and how it affects the interest rates down the line. From a trader’s perspective, understanding the path of the rate hikes can help in many ways.
From a day trading perspective, short-term traders can utilize the information to take strategic positions. Long-term or swing traders can also use the information to understand what is driving the markets.
As you might already know, interest rates are at the very core of fundamental drivers in the markets. Investors and traders alike use interest rates which also dictate the flows in the markets.
The reason behind this is simply to earn higher yields. An excellent example of this can be seen over the past 10-year period.
Why are interest rates so important?
After the 2008 global financial crisis, the Federal Reserve started its quantitative easing operations. As interest rates hit all-time lows and the central bank pumped liquidity into the markets, investors were seeking out investments that could yield higher returns.
As a result of the cheap money from the West, investors parked their funds into the emerging market economies. Interest rates were of course much higher. After a decade of keeping rates low, the Fed then started to raise rates again.
This eventually led investors to pull out the funds from the emerging markets as the cost of borrowing for the U.S. Dollar increased.
In technical terms, one could call the above as carrying trade. Carry trade is an arbitrage concept that takes advantage of interest rate differentials.
In the immediate aftermath of the financial crisis, the Japanese yen was a preferred currency for carrying trade strategies against the U.S. Dollar.
As the Bank of Japan began its massive liquidity operations, investors could borrow the yen at a lower price, convert the yen to the Dollar and invest in the U.S. stock markets.
As a result, the returns from the stock investments were high enough to cover the rate of interest.
One might ask how this information is useful for traders? Well, this brings us back to the topic of discussion, the fed funds rate.
If you thought that you could not trade interest rates, then you are wrong. There are derivative markets that allow traders to speculate on interest rates as well. Among the many such futures contracts, the Fed funds futures rate is one such contract.
It is, interesting to say the very least.
What is the Fed funds futures contract?
The Federal funds futures are derivative contracts of the fed funds rates that the Federal Reserve controls. The fed funds futures contracts represent the market opinion of where the short-term interest rates will be at the time of expiry.
The fed funds futures contracts are traded on the Chicago Mercantile Exchange (CME). These are cash-settled contracts on the last business day of the month. There are different variations of the Fed funds futures contracts.
You can trade the contracts from every month to as far as 36 months.
The Fed funds futures contracts exist because they offer the opportunity to hedge. Banks, investors, hedge funds use the fed funds futures contracts to protect against interest rate fluctuations.
According to the CME Group, the main benefits of using the Fed funds futures (or derivative) contracts are as follows:
- Provides a gauge of the market expectation on the Fed’s actions (in regards to setting interest rates)
- Because the contracts are standardized and exchange-traded, there is transparency and liquidity
- The contracts allow investors and traders to manage risk or hedge the changes in interest rates
Of course, traders can also use these contracts to speculate purely. Besides futures contracts, you can also trade the Fed funds options.
Based on the market opinion, you can typically predict whether the Fed will hike interest rates or not.
In this article, we only give a brief overview of the topic. To learn more about how the Fed funds futures contracts can be used to predict the Fed rates, then this essay is a great starting point.
Below are the technical details on the Fed funds futures contracts.
|Venue||Symbol||Price quotation||Listed contracts|
|Chicago Mercantile Exchange||ZQ||100 minus the average daily Fed funds overnight rate||36 calendar months|
Fed funds futures contract chart
The chart below gives an example of the Fed funds futures contract. The contract is the December 2018 expiry (ZQZ18).
The price is quoted as 100 minus the daily Fed funds overnight rate.
When you use the 100 minus to the price quote what you get is in effect the Fed funds rate. The above chart is inverse to the rates.
For example, a price of 97.755 infers, 100 – 97.755 which is 2.245% or 2.25%. What does the above chart tell you? The above chart shows the market expectations of what the Fed funds rate will be for the contract expiring December 2018.
In this case, the markets are expecting to see the Fed funds rate at 2.25%. At the time of writing, the Fed’s rate was at 1.75% – 2.00%. The Federal Reserve had then hiked interest rates by 25 basis points a week later.
As traders, you might have come across commentary stating that “the rate hike is fully priced in.” If you wonder what that phrase means, it simply refers to the point that the futures markets have priced in the rate hike.
The Fed Watch Tool
The CME Group takes the above chart a step further and also publishes the probability factor. The probability factor keeps changing on a day to day basis. This happens as new economic reports are released. Derivative traders change their opinion on the interest rates accordingly.
Also known as the Fed Watch, this is a handy tool that traders can use to gauge the market sentiment. You can directly access the Fed watch tool from here, and it is free.
The Fed watch tool is easy to use.
On the very top are the different FOMC meeting dates for the year. Clicking on each of these gives you a quick overview of the probability. For example, in the picture below, we see that there is a 77% chance for the Fed to hike rates to 2.25% – 2.50% for the December 2018 FOMC meeting.
While you could also gather this information by only looking at the Fed funds futures chart, the important thing to note is that the Fed watch also accounts for the options contracts. Combining the open interest in the futures and the options contracts, the Fed watch tool also gives the probability on the interest rate decision.
The next view shows the probability table.
The highlighted area shows the meeting dates and the probability of a rate hike. The above chart shows that there is a 77% chance for a rate hike in December and a 72% chance of a rate hike in January 2019 if the Fed left rates unchanged at the December meeting.
From the above, we now have an idea of what the market opinion is shaping out to be.
You can also look at future meetings to get an idea of the market probability. Of course, it is important to note that prospects can change as the markets adjust their expectations. So just because there is a 77% chance of a rate hike in December does not mean that the Fed will hike rates.
So far, in this article, we learned the tools that traders can use to determine the probability of interest rates. In the next section, we will see how this information can help you in your trading. Most importantly, you will learn how to combine the above fundamentals with technical analysis.