Overview
In this lesson, we will discuss using futures data to predict changes in the federal funds rate. Changes in the federal funds rate have a critical impact on the yield curve, value of bonds, and economic growth. While this discussion will not go into depth for those topics, it will help you understand the relationship between investor expectations and how you can safeguard your portfolio.
Gathering Information
The first step in predicting interest rate hikes is to gather information about current prices from the Federal Reserve and investor expectations from futures prices on the 30-day federal funds rate. In order to understand why futures are useful, please review the following:
- Investopedia Article on Federal Funds Futures
- Journal Article on Using Futures to Predict Rate Hikes
- Contract specs on the 30-day federal funds rate
Now, let’s start the process of gathering the data to make predictions! We are going to start with acquiring data from the Federal Reserve website. Specifically, we are looking for the current target rate set by the Fed. This is usually in the latest minutes released by the Fed. If we navigate to the FOMC calendar on the Fed’s website:
Find the last FOMC meeting and review the PDF, the header and relevant sections can be seen below:
Here, we can see that the current target federal funds rate is 1-1/14 (meaning 1.25%). The next step is to find the latest futures price on the 30-day federal funds rate futures. We first navigate to the CME group site for the 30-day Federal Funds Rate (the easiest way to do this is to just google that term).
This page shows the current quotes; however, we want a more stable figure to help us in our analysis. Click on the Settlements to see finalized settlement prices from the prior business day.
Here, we can see that the last settled price is 98.8425. According to Robertson and Thornton (Click here to access paper), the futures quite can be thought of as the average price for Fed funds in a particular contract month.
In this case, the implied yield on the federal funds rate can be calculated as 100 – 98.8425 = 1.1575%.
The last piece of the puzzle is to note the date of the next FOMC meeting and select the appropriate futures instrument. Above, we have selected the November futures price (although this should usually be determined afterwards). Looking at the FOMC calendar meeting, we observe that the next FOMC meeting is October 31, 2017. Therefore, we selected the futures instrument with the nearest maturity to the next FOMC meeting, and represents the most relevant instrument to gauge investor sentiment.
Putting it All Together
Using this information we gathered, we can apply Geraty’s formula to determine the probability of an increase in a federal reserve hike (click here to access the article). The other key factor is what the expected rate hike will be. Based on the information above, we see that the implied yield of 1.1575% exceeds the federal funds rate target of 1.25%; therefore, we can determine that investors are not expecting an increase in the federal funds rate. Instead, let’s examine a 25 basis point reduction.
The formula is presented below, in addition to the application of the inputs gathered above.
Based on the analysis, there is an 8.0% probability of a reduction in interest rates. From an investor’s perspective, this implies that the federal funds rate is unlikely to change at the next FOMC meeting!
Summary
Keeping in mind there are adjustments to be made to the formula (read the literature I have posted links to!), this is a simple way to gauge investor expectations. This strategy becomes even more powerful when combined with your own interest rate projections, topics we will cover at a later date!
