After posting Part 1 of The Fed 101 I noticed that Justin Lahart of the WSJ wrote a nice piece about the fundamentals of the Fed's policy. His piece addresses what we went over in Part 1 in a Q&A format. I reccommend reading it if you want to be sure you've the fundamentals down (WSJ subscription required).
For Part 2, I want to focus on a more esoteric angle of the Fed and its relationship to financial markets and the economy. First among these topics will be "predicting" what the Fed will do at its FOMC meetings by using Fed Funds Futures (FFFs). Unlike a simple bond futures contract, where a contract represents a specified rate to be had on a specific day, the FFF contract is an average of the 'daily effective federal funds rate' during the month of the contract- the daily effective federal funds rate is a weighted average of all federal funds transactions during the month. The CBOT offers contracts ranging from the current month to 24 months out and each contracts has a nominal value of $5,000,000. To read FFF data from the CBOT you must understand that the effective federal funds rate is 100 minus the price of the contract. Hence, a current market price of 96.89 for a one-month contract expiring at the end of February means that the market currently forecasts an average Fed Funds Rate for February of 3.11 percent (100 – 96.89). Because the Fed Funds rate actually fluctuates a bit day-to-day (it isn't set, its a 'target' of the Fed policy we talked about in Part 1), you might attribute the .11 above the 3-handle to inherent volatility. This would be accurate enough to get an idea of what Fed policy might be, but truthfully a trader in the FFF market would call the .11 the "bias" or "hedging premium." The Federal Reserve Bank of St. Louis says that, "One possible explanation for the hedging premium is that large banks, which regularly finance a significant amount of their loan portfolios in the spot market for federal funds, also participate in the federal funds futures market. Such institutions may use the futures market to hedge against increases in the spot funds rate. If institutions that are hedging against a potential increase in the spot rate are dominant, there could be a premium built into the futures rates." But for most purposes, including that of the retail investor, knowing how to infer the likely fed funds rate from the FFF market is as simple as looking up the contract for a given month on the CBOT, finding the contract for the month you want to speculate about, and comparing the rate we're at now with the rate implied in the FFF market. Because we're at 3.50% right now, and the FFF market implies an average fed funds rate of 3.11% during the entire month of February, its relatively accurate to say that the market expects a 50bps cut at the January 30 meeting (because there is no subsequent scheduled meeting before the expiration of the Feb 08 FFF contract).
Now, I say its "relatively accurate" because there are some kinks you have to deal with if you want to really understand the probability of certain Fed policy (like when CNBC reports there is a 50% chance of a 50bps cut). I'll leave that part of the equation out for this post (you can read all about it here) and just recommend using the Federal Reserve Bank of Cleveland's regularly updated chart on meeting outcome probabilities.
Again, post any questions and I'll try to respond to them quickly.
For Part 2, I want to focus on a more esoteric angle of the Fed and its relationship to financial markets and the economy. First among these topics will be "predicting" what the Fed will do at its FOMC meetings by using Fed Funds Futures (FFFs). Unlike a simple bond futures contract, where a contract represents a specified rate to be had on a specific day, the FFF contract is an average of the 'daily effective federal funds rate' during the month of the contract- the daily effective federal funds rate is a weighted average of all federal funds transactions during the month. The CBOT offers contracts ranging from the current month to 24 months out and each contracts has a nominal value of $5,000,000. To read FFF data from the CBOT you must understand that the effective federal funds rate is 100 minus the price of the contract. Hence, a current market price of 96.89 for a one-month contract expiring at the end of February means that the market currently forecasts an average Fed Funds Rate for February of 3.11 percent (100 – 96.89). Because the Fed Funds rate actually fluctuates a bit day-to-day (it isn't set, its a 'target' of the Fed policy we talked about in Part 1), you might attribute the .11 above the 3-handle to inherent volatility. This would be accurate enough to get an idea of what Fed policy might be, but truthfully a trader in the FFF market would call the .11 the "bias" or "hedging premium." The Federal Reserve Bank of St. Louis says that, "One possible explanation for the hedging premium is that large banks, which regularly finance a significant amount of their loan portfolios in the spot market for federal funds, also participate in the federal funds futures market. Such institutions may use the futures market to hedge against increases in the spot funds rate. If institutions that are hedging against a potential increase in the spot rate are dominant, there could be a premium built into the futures rates." But for most purposes, including that of the retail investor, knowing how to infer the likely fed funds rate from the FFF market is as simple as looking up the contract for a given month on the CBOT, finding the contract for the month you want to speculate about, and comparing the rate we're at now with the rate implied in the FFF market. Because we're at 3.50% right now, and the FFF market implies an average fed funds rate of 3.11% during the entire month of February, its relatively accurate to say that the market expects a 50bps cut at the January 30 meeting (because there is no subsequent scheduled meeting before the expiration of the Feb 08 FFF contract).
Now, I say its "relatively accurate" because there are some kinks you have to deal with if you want to really understand the probability of certain Fed policy (like when CNBC reports there is a 50% chance of a 50bps cut). I'll leave that part of the equation out for this post (you can read all about it here) and just recommend using the Federal Reserve Bank of Cleveland's regularly updated chart on meeting outcome probabilities.
Again, post any questions and I'll try to respond to them quickly.
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2 comments:
Nice post.
Interestingly, as of today, Bloomberg's survey of economists produced a median of 3.125% for the new target, so they seem pretty split between a 25bp and a 50bp cut. But the survey seems to lean more toward 25bp, as the average estimate is 3.18%.
Personally, I think cutting more than 25bp would be moving too fast, especially after the inter-meeting cut. Inflation is going to have to be a concern sooner or later.
Some great points.
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