It has been awhile since the market focused on the Fed funds futures as tool for telling us what the Fed may do, but it is time to start watching this forecast market again. The Fed fund futures market is telling us that the first big rate increase is likely to happen in June. Of course, just looking at the curve and seeing at what month the Fed fund futures will be at or above 25 bps is a very simple way of looking at market expectations, but we can extract more information.
The market information in the futures can tell us the probability of a change in rates by the central bank since we know the dates when the Fed will act and when the futures will expire. If you look at the FOMC meeting dates and see how they relate to the Fed funds contract that will expire around those meeting, you can estimate the chance of a Fed move. A simple measure of the change of at least a 25 bps increase at July FOMC meeting is 81 percent as measured on the CME Fed watch website. We may have some issues with the actual way that this is calculated, but it provides a good handicap of Fed changes. The website provides regular updated probabilities for each FOMC meeting using the Fed funds futures curve.
The following graph shows the probability the FOMC raising interest rates at each of the next five committee meetings. For the December 2014 FOMC meeting which will occur this week, there is a less than 45 perfect chance that the Fed fund futures market thinks there will be a 25 increase. By March 2015, the probability is a coin flip for whether the Fed will raise rates. However, for the July meeting the futures market is guessing that there will only be a 19 percent chance of rates still being at the zero bound and an 81 percent chance that the Fed will have rates increased to at least 25 bps. The probabilities flip in favor of an increase in rates for the June meeting.
These market probabilities of some FOMC action are constantly changing and will be constantly priced in options and futures. This can be a good tool for handicapping rate changes in a manner that is significantly more measurable than a survey. The futures serve as a good guess of market sentiment through the actions of market participants and not just their opinions. The rates market will change significantly in 2015 which will be the key theme in for the new year.
The following graph shows the probability the FOMC raising interest rates at each of the next five committee meetings. For the December 2014 FOMC meeting which will occur this week, there is a less than 45 perfect chance that the Fed fund futures market thinks there will be a 25 increase. By March 2015, the probability is a coin flip for whether the Fed will raise rates. However, for the July meeting the futures market is guessing that there will only be a 19 percent chance of rates still being at the zero bound and an 81 percent chance that the Fed will have rates increased to at least 25 bps. The probabilities flip in favor of an increase in rates for the June meeting.
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