New Regime: Target Range for Fed Funds, Not a Fixed Point

A key shift at the Federal Reserve that many in the market have not grasped is that the Fed funds target is a range now not a fixed point as in the past.  Yet many continue to calculate fair value for the Fed funds futures contract the same way they did previously.  

The current target is 0-25 bp.  The effective average, which is what the Fed funds futures contract is linked, has been averaging around 12 bp, near the middle of its range. The effective average is weighted by volume.  

Suppose the Fed were to hike rates.  The new range would be 25-50 bp.   Assuming a hike in June, the effective Fed funds rate may average 37 bp in July.  There is a meeting July 28-29, back-to-back rate hikes would be unreasonable to expect.  The implied yield of the July Fed funds futures is 24 bp and with the August contract at 29 bp.  

Looking further out, consider the December Fed funds futures contract.  It implies a yield of 56.5 bp.  If the first hike brings the fair value to around 37 bp, a second hike would bring fair value to about 62 bp.  Again, this assumes that the effective rate averages around the middle of the Fed's range.  This would suggest the market is discounting not only one hike but 80% (20 bp) of a second hike.

Market participants can not be confident that the effective Fed funds rate will average around the middle of the target range.  For the purposes of this exercise, we assumed the middle of the range as the neutral assumption and note that that is about the effective Fed funds current average. Owing to the element of uncertainty injected by the Federal Reserve's adoption of a range rather than a point target, there is good reason to expect somewhat higher volatility for contracts that are pegged
to the effective Fed funds rate.