Saturday, June 21, 2008

Fed Funds Futures Predictions on Future Rate Increases

Looks like the futures market for interest rates are predicting that the Fed will raise rates in the future. I've posted a graph that interprets the futures prices, as of 6/18/2008. Remember, the futures market predicts future rates via the "price of the contracts" traded for each future Fed meeting.
The x-axis shows the date for each Fed meeting (i.e. July 2008 Fed meeting, etc.) The dark blue line shows the implied rates that the contracts trade at for each meeting, with the right-hand y-axis showing these implied rates...The left-hand axis shows the probability of various rate increases at each meeting above the current 2.00% level. (Notice there is no contract implying a rate cut...)

Let's take an easy example: The current rate is 2.00%. The futures market predicts that the Fed Funds rate will be 2.25% in Sept. 2008. This 2.25% represents a 25 basis point increase over the current rate of 2.00% (or 0.25%)...Therefore, if you look at the red line, it shows that the market is predicting a 100% chance that the Fed will raise rates at the Sept. 2008 meeting to 2.25%. However, at this same Sept. meeting, the market is only predicting a 50% chance that the Fed will raise rates 50 basis points to 2.50% (the green sloped line.)

What is the chance the Fed raises rates from 2.00% to 2.50% at September meeting? The simple math goes like this. If the current rate is 2.00%, and the futures market for the Sept 2008 meeting implies a rate of 2.25%, then the difference (2.50-2.25=0.25) divided by the increase (2.50-2.00 current rate = 0.50%) = 50% chance that rates will be 2.50% in Sept. '08 vs. current rate...

That's how all these talking heads calculate what the Fed might do...These markets rely on the what is called the "wisdom of crowds."

The bottom line for you and I is that if the Fed raises rates to battle inflation, then equities should and will fall. That's because higher interest rates discount future cash flows more heavily, making them worth less. I've posted Toles' cartoon again, because it's that good.