Tuesday, August 19, 2008

Fed Funds Futures Predict Rate Hikes in 2009

How to read this chart*

The futures market for Fed Funds Futures
are currently predicting a 36% chance of a +25 basis point rate hike in January 2009. This move would change the current Fed funds rate of 2.00% to 2.25%. The probability of a +25 basis point rate increase goes to 92% in March of 2009. The contracts are here.

This key rate is the Fed's primary tool to balance inflation risks with economic growth. As we all know, the Fed cuts this discount rate when times are "bad" to stimulate spending and investment. And conversely, the Fed raises this rate when there's "too much money" out there in supply, which often leads to inflation. Too much money results in people bidding up prices of things (like oil, food) and as a result, inflation erodes the future earning power of cash flows. Think about it this way; an interest rate (discount rate, etc.) is just the cost or price of money. Money's "price" ebbs and flows just like anything, in response to supply and demand. The Fed can lower this rate to encourage people to borrow money (seek credit), and this money will be put to use in assets that produce a greater return than the cost of the money. That's why the yield curve is so important, and a leading indicator of economic sentiment. The yield curve just shows the "price" of money across different time periods. We'll leave the yield curve for another day.

The reason that the discount rate is watched so much these days is that there is a battle going on in the capital markets. The Fed was raising rates last year due to economic growth that was mostly due to the easy credit available out there. This easy credit was creating inflation in all kinds of assets (think housing and the stock market for the easy examples, but food and oil were the other two.) So to control consumption, the Fed can raise these rates to curb consumption, thus controlling prices. But a funny thing happened. Bear Stearns forced the Fed's hand, and rates had to come down, liquidity (money) had to be injected into the system. Anytime you create an oversupply of something, its price falls. The price of short-term money fell from 5.75% to its current price of 2.00%.

However, the value of the dollar was already so low, that all this did was add more money to the system that encouraged another asset bubble to appear in commodities. Commodities are an inflation hedge, so this was a positive feedback loop. Now the Fed has its current dilemma: Rates at 2.00% were too low to cut any further to "keep the US from going into a recession" since the housing/credit/corporate profit bubbles were popping. However, if the Fed raised rates to fight the inflation that was occurring in food and oil prices, (which it helped sustain due to the extraordinary actions it took to bail the financial system out by lowering rates), then it risked pushing the US into an economic contraction (recession) without prices coming back to earth since the dollar is still so low in value. Stagflation is a situation where prices still climb but economic growth is flat or low. Japan went through this in the 90's.

The Fed will need to raise rates, and the futures market predicts the beginning of this change in sentiment in 2009. Raising rates in response to inflation expectations will have all kinds of implications for US equity markets, namely, market values will fall because the 10-year treasury yield will move higher, discounting all future cash flows to lower values. Some think that once 10-year yields move above 4.5%, the Fed will have to raise rates, no matter what the financial sector is doing.

But if you want to assume away the discounting mechanism of the markets, all you need to know is that the presidential election is in November 2008. After all the promises have been made, it won't matter. The Fed will no longer be working for the politicians, and will do what they were created to do.

* The blue line represents the current "implied" fed funds rate for each month going forward. The y-axis on the right is related to this blue line. Market participants predict, for example, that at the Sept. 2008 Fed Fund meeting, the Fed will leave rates at 2.00%. You can see what the market predicts over the longer time periods.

* The other lines represent the probabilities that the Fed will raise the current 2.00% rate by 25, 50, or 75 basis points. (25 basis points is 0.25%). The pink line shows the probability that the Fed will raise rates the current rate at 2.00% by by 25 basis points to 2.25%. The y-axis on the left matches with these scenarios. In Feb. 2009, the pink line shows that the probability the rate moves 25 basis points to 2.25% is 72%. In March, it goes to 92%. The way you calculate this probability is as follows:

Subtract the implied rate in Feb 2009 (2.18%) from target rate (2.25%) = (2.25-2.18)= 0.07
Divide 0.07 by rate increase (+25 basis points) = 0.07 / 0.25 = 0.28
Subtract 0.28 from 1 = 1 - 0.28 = 0.72
This is the probability that in Feb 2009, the Fed will raise rates from 2.00% to 2.25%...