“F” is for Forecasting the Fed Funds Rate by Following Futures

Editor's note: We've dusted off this article that originally ran on April 21, 2015. It's worth a rerun because its usefulness for help tracking the Federal Reserve's potentially too-close-to-call interest rate decision is just as important now as it was then. You can find Fed funds futures pricing on the CME Group website. The Fed has two policy meetings left this year: one on October 28-29 and another December 16-17.

One of the biggest questions in the financial markets this year is whether the Federal Reserve will raise short-term interest rates from near zero. And if so, when?

The Fed has a tool for tinkering with short-term rates. It’s called the Federal funds rate, and it’s the interest rate that commercial and retail banks charge other banks to borrow their reserves held at the Fed, our central bank. That makes this little number an important benchmark for financial markets, and it’s closely watched by investors and economists. In fact, they spend a lot of time and energy trying to decipher “Fedspeak” for a clue about what’s next for the Fed funds rate. There’s no shortage of opinions from pundits about the Fed’s next move. And you know what they say about opinions …

For many market participants, there’s a better way to try to predict what the Fed may do with its funds rate: analyze the 30-day Fed funds futures (/ZQ). The /ZQ reflects the opinions of real traders with real money at risk. After all, how many economists put money behind their predictions?

The Formula

There’s a simple way to read the Fed funds futures and determine what traders are expecting and when they expect it. The formula: start with a basis of 100 and subtract the last price of the contract month you’re analyzing. For example, look at the last price of the SEP 2015 contract of 99.745 in Figure 1. Subtract it from 100 and you get 0.255. That means traders expect the federal funds rate to be at 0.25% in September. Now look at the DEC 2015 contract and repeat the calculation: 100 – 99.585 = 0.415, or just over 0.41%. Traders expect the federal funds rate to rise by December.

Mood Shift

The data in Figure 1 was captured after the March 18 Fed meeting. You can see from the green running up and down the “change” column that market expectations shifted. At that meeting, the Fed indicated it would raise its funds target at a slower pace than was previously expected. This caused Fed funds futures to rally, reducing the probability of a rate hike and pushing any eventual hike well into the future.

This brings up an important point: the Fed funds futures change all the time as traders buy and sell contracts based on their expectations for future rate hikes. That means with each new drip of fresh economic data, including the closely watched non-farm payrolls or inflation reports, the Fed funds futures could change, and so too could expectations for a hike in the Fed funds rate.

The next time a Fed meeting rolls around or an economist is jawing on CNBC about rate hikes, check the Fed funds futures. Do they track? This single pricing screen can be one of the most reliable sources of data for expectations for Fed policy. Remember, it’s expectations for interest rates that help set demand for interest rates, driving their value up and down. That makes the Fed funds markets potentially valuable when making investing decisions based on the future of interest rates.