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March 15, 2010 Monday 8:00 PM EST
SECTION: NEWS & COMMENTARY; Credit Markets
LENGTH: 1248 words
HEADLINE: Fed funds futures no crystal ball on rate hikes
BYLINE: Deborah Levine, MarketWatch mailto:firstname.lastname@example.org.
Deborah Levine is a MarketWatch reporter, based in New York.
NEW YORK (MarketWatch) — Fed funds futures are often used as a window into when institutional investors expect the Federal Reserve to hike rates. But this little-understood market has weaknesses as a predictive tool, say traders.
While huge at $440 billion, trading volume has declined since the Fed last cut rates in December 2008, bringing its benchmark lending cost to near 0%. Plus, many institutions use these contracts as hedges against other positions, says George van Schaick, a mortgage repo trader at Barclays Capital.
Both factors can cloud the interest rates priced into the contracts.
Then there’s the time element. Uncertainty about what may happen in the economy between now and December, the point at which the market is pricing in a 68% chance of a rate hike, raises questions about reading too much into these contracts.
“December is so far away and there will be so much volatility between now and then,” said Mary Sirois, an independent trader and market maker in fed funds futures.
When the Fed will start raising interest rates is important to everyone from bond traders to credit-card borrowers, from individual stock pickers to investors in commodities. That’s because the rate the Fed sets for short-term loans between banks is used as a benchmark for many types of corporate and consumer loans, and higher loan rates are expected to temper a company’s ability to expand and a household’s ability to buy.
So even while flawed, fed funds futures can be helpful as a barometer for what the market is expecting about rates, some analysts and investors say.
“I look at probabilities and find them useful to see what traders are thinking,” said Jack Ablin, chief investment officer at Harris Bank, who says he doesn’t trade them. “I use it as consensus against which I gauge whether I’m more aggressive or bullish or bearish.”
Trading of fed fund futures is driven mostly by hedge funds and short-term money- market traders, according to bond, foreign-exchange and equity traders. The CME Group (CME) says fixed-income portfolio managers and bank treasurers also participate.
They use these contracts, which trade over the CME Group’s Chicago Board of Trade, to offset other investments that are sensitive to changing interest rates, or simply to engage in short-term trades.
“I use them as a hedging tool versus my overall position in the market and when I disagree with market expectations,” said Ray Remy, head of fixed income at Daiwa Securities America Inc., one of the 18 primary government security dealers that trade directly with the Fed.
As a type of interest-rate future, the contracts are part of the broader and vitally important money market. Seizures two years ago in this vast market, which includes money-market funds and commercial paper, were at the heart of the U.S. financial crisis.
Traders buy them for a certain month. Their value is based on the buyer’s expectation of where the federal funds rate will be that month.
One factor that may hamper the accuracy of fed funds futures is that volume has dropped since the Fed last changed its target overnight interest rate.
And while trading activity has picked up in the last couple months, volume is still pretty low for contracts six to nine months in the future, according to the CME.
These thin trading conditions several months out matter because that’s the time period in which many economists and analysts predict the Fed will start raising rates.
The most active fed funds futures contract right now is the one maturing in April. The December contract has about a quarter of that volume.
Sirois, the fed funds futures trader, said she tends to trade the futures between contracts maturing in upcoming months versus later contracts, attempting to profit on whether the spread between the two will grow or shrink.
Researchers at the Federal Reserve Bank of Cleveland said, in 2006, the fed funds futures market isn’t terribly good at predicting actual rate moves more than a few months into the future, even when the Fed is actively adjusting its target.
Fed fund futures track the effective overnight lending rate between banks, set by the Federal Reserve Bank of New York every business day. When the Federal Open Market Committee announces its target lending rate, the New York Fed conducts operations in money markets to get the actual, or effective, rate as close to the target as possible.
In December 2008, the Fed lowered the target rate to a range of zero to 0.25%. The effective rate has sat between 0.1% and 0.17% this year, according to the Fed.
When the Fed is in the process of raising or lowering the target rate, fed fund futures trading is more active.
It reached a multi-year high of more than 76,000 contracts on average each day in 2008, according to CME Group. That amounts to about $380 billion in daily trades on average that year.
But in 2009, volume dropped off to about 41,000 contracts a day.
This year, volume is picking up again.
In March, volume has jumped to more than 88,000 contracts daily on average, or to $440 billion a day. That volume is on par with the average trading volume for Treasurys in January, says the Securities Industry and Financial Markets Association.
Realm of repo traders
So-called repo dealers make up another group of users of fed funds contracts. These dealers are part of the way banks arrange intraday funding, though they’ve been less active in fed funds futures trading since the target became a range and the central banks let excess reserves balloon.
In repurchase agreements, one party — like the Fed — agrees to buy securities from a dealer for a specific period of time and a set price before returning that security. The Fed used to conduct billions in repo transactions almost every day, mostly just overnight, to get the effective fed funds rate as close as possible to policy makers’ target.
Whether the effective rate was above or below the target rate was an indication of the availability of cash, said Barclays Capital’s van Schaick.
So fed funds futures were used by banks as a hedge that their funding costs would be different than the Fed’s target rate, he said.
While under-the-radar, these trading arrangements belie the importance of this market. Disruptions in the repo market two years cut off a major source of short-term funding for the investment banks using this market.
Around that time, the Fed moved away from repo transactions to other liquidity measures and encouraged banks to keep massive reserves. The shift changed the utility of fed funds, van Schaick said.
“In this environment, it’s less meaningful because the target is a range and the market has more than $1 trillion in excess reserves,” he said.
Still, what’s being indicated by the fed funds futures remains relevant because market participants need to hedge their rate risks, he said. But with so much in their coffers already, they don’t need to borrow much from each other to hedge those transactions.
Another big user of fed funds futures are Fannie Mae (FNM) , Freddie Mac (FRE) and the other government-sponsored enterprises that finance the vast majority or mortgages in the country, he said.
The fed funds futures’ “relevance will come back when the Fed has drained a significant amount of those reserves — like the majority,” van Schaick said. “At that point, banks may need to borrow money from one another.”
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