The Federal Funds Futures Market Is Predicting a Rate Cut

Published 9/16/07 (Modified 3/9/11)
By MoneyBlueBook

The Federal Reserve sets monetary policy largely by targeting the federal funds rate, which is a key short term rate that determines rates for banks, credit card loans, home equity loans, and other types of consumer and corporate loans.

Since the Fed is meeting in a few days to decide whether it will change the federal funds rate, let's get slightly technical and talk about one of the ways to predict what the Federal Reserve will do

In normal times, the federal funds futures market is usually a good predictor of what the Federal Reserve will do over the next several months. However, times are a bit out of whack right now and there is a growing disconnect between what people are fearing or hoping will happen and what a calmer and less pressured Fed will actually do.

Federal funds futures are contracts that are bought and sold on the Chicago Board of Trade and used mostly by speculators who want to gamble on interest rates. The prices reflected by the futures contracts represent investors and speculators' collective wisdom (or folly) about where short term interest rates are headed.

What Does the Fed Funds Futures Crystal Ball Suggest?

Based upon Friday, September 14's market close, the 30 day federal funds futures contract for the October 2007 expiration is currently pricing in a 100 percent probability that the Fed will decrease the target rate by at least 25 basis points from the current 5.25% to 5% at the Federal Open Market Meeting on Tuesday, September 18.

In addition, the 30 day federal funds futures contract is pricing in a 58 percent probability of a further 25 basis point decrease in the target rate to 4.75% (versus a 42% probability of just a 25 basis point rate decrease).

So, the futures are telling us that a cut is a virtual certainty at the Fed's next meeting and that a greater cut is likely. I would urge caution in relying on the futures contract numbers alone though because the Fed has not indicated that it is leaning towards such a cut and the Fed funds futures market has not always predicted accurate results in the past. Studies have demonstrated that the Fed funds futures market has a relatively high degree of forecast reliability only about 30 days out, so probabilities beyond the next month are also shaky at best as well.