Thinking About Fed Funds

The weighted (by volume) average of Fed funds on New Year's eve was 5 bp. The range that day briefly touched the lower end of the 0-25 bp target for the first time since the end of Q3. Throughout Q4 09, the effective Fed funds rate was very stable between 11 and 13 bp--the middle of the target range.

Recall that the Fed funds futures settle at the average effective rate not the target rate for the given month. The FOMC meeting this month concludes on the 27th. No one expects the Fed to change rates at that meeting and it makes sense then that the Jan Fed funds futures is implying a 12.5 bp average Fed funds rate. The Feb-April contracts implied yields rise 2-3 bp a month. The May contract jumps 6.5 bp to 27 bp. Ironically though there is no meeting in May and the April meeting is late in the month (27th-28th), so the May contract is a better guide to expectations in April. The May contract then implies about an 8% chance of a Fed hike at the April FOMC meeting.

The June meeting is similarly late in the month (22nd-23rd). If the Fed funds effective rate during the month remains in the middle of the current target range and the Fed hikes on June 23rd, the fair value for the June contract (23 days at 13 bp and 7 days at 50 bp = ((23*.13)+(7*.50))/30 = 21.6 bp. Yet the June contract is implying a yield now of 31.5 bp. We can check our work by looking at the July contract as there is no FOMC meeting scheduled then. The July contract is implying a 42 bp effective Fed funds rate. That would seem to imply about a 68% chance of a 25 bp rate cut in June (17/25).

The discrepancy between the June and July contracts appears to reflect the assumption that as the Fed prepares to deliver its first hike, it will allow the effective Fed funds rate to creep toward the upper end of its current target.

For several quarters now we have pencilled in the first hike for the August FOMC meeting. The August Fed fund futures imply an average yield of 53.5 bp. No matter how one slices or dices it, the August contract have a full 25 bp hike more than fully discounted.

If we assume that in the first 10 days of August, the Fed funds average 25 bp and the Fed hikes by 25 bp on August 10 and that the new target is achieved over the remainder of the month, the fair yield for the Aug Fed funds futures contract is ((25*10)+(50*21))/31 or 42 bp, which is 11.5 bp lower than currently implied. The discrepancy is even larger if one assumes that Fed funds does not average 25 bp in the first part of Aug.

The pricing of the Fed funds futures then seem particularly aggressive and at risk of some disappointment. And that risk, if realized, would likely be seen as dollar negative. There a number of factors that disappoint the market. This week's employment report poses event risk. Disappointment with either the non-farm payroll figure (Bloomberg consensus is now for a 4k decline) or the unemployment rate (Bloobmerg consensus is for a small increase to 10.1%) could be such a catalyst.