Futures: The Key to Predicting Fed Moves
By Don Luskin
Special to TheStreet.com
2/23/01 9:40 AM ET
The Federal Reserve isn't going to tell you what it's going to do next with interest rates. Or when. Here's why -- and what you can do about it.
Go to the Fed's Web site and you'll see its meeting schedule -- and a friendly invitation to drop by the next time you're in the neighborhood: "The public is invited to attend meetings
that are open under the Government in the Sunshine Act."
But when you click on the links for any of the interesting policy-setting meetings, such as the FOMC, and you'll find that these meetings are "closed to public observation by Order of
the Board of Governors because the matters fall under exemption(s) 9(A)(i) of the Government in the Sunshine Act (5 U.S.C. Section 552b(c)), and it was determined that the public
interest did not require opening the meeting." Determined by whom? By the Fed, of course.
White Noise
You can listen to Alan Greenspan's congressional testimony or his many speeches or the dozens of speeches by lesser Fed governors and regional Reserve Bank presidents.
But these speeches have a worse signal-to-noise ratio than an AM radio in a 1971 Toyota. If you can sift through all the platitudes and econometric bunkum, you might be able to
tease out a few clues. But half the time, these clues can mislead you.
I think the way to get the best estimate of upcoming Fed actions is to learn to read the futures market. The Chicago Board of Trade does a brisk business in futures contracts on the
fed funds rate, and if you can master a little bit of simple algebra, those contracts are the closest thing we've got to a peephole into Alan Greenspan's soul.
That's because these futures reflect the entire marketplace's collective wisdom about what the Fed is going to do. The prices of the futures are set by real traders risking real
money; what they think carries a lot more weight than the babbling pundits on CNBC.
Here's how the futures work.
Whip Out Your Calculator
The fed funds futures expire on the last day of each month. Their value at expiration is based on the average fed funds rate for that month -- so their value today is based on the
market's best guess of what that average will be. The futures are quoted as 100 minus the average fed funds rate. If you see a quote of 94.5, that means a funds rate of 5.5% -- the
quote is 100 minus 5.5.
The funds rate today is 5.5%. So if you saw the March futures at 94.5%, that would mean that the market thinks that the funds rate will average 5.5% during the whole month of
March. The FOMC meeting is on March 20, so that would mean the market expects no change in rates before the meeting, at the meeting or after the meeting -- no change in March
at all.
Yesterday the March futures closed at 94.715. Subtract that from 100 and you get 5.285 -- that means the market is expecting the funds rate to average 5.285% over March. That's
21.5 basis points less than the funds rates today. So the futures market is expecting the Fed to lower interest rates.
But by how much and when? That's easy to figure out. We know that there are 20 days in March up to and including the FOMC meeting, and then another 11 days to the end. If we
suppose that the Fed won't change rates on any day other than March 20, then we know that the value of the futures should be the average of 20 days at the present funds rate of
5.5%, and then 11 days at some lower rate.
Let's assume that lower rate is 5.25%, a 25 basis-point cut. The average of 20 days at 5.5% and 11 days at 5.25% is 5.411%. But that's higher than the 5.285% average funds rate
predicted by the futures. That must mean that the futures are predicting the Fed will cut rates by more than 25 basis points.
So let's try it again with a 50 basis-point cut. The average of 20 days at 5.5%, and then 11 days at 5.0% is 5.323%. That's still higher than the 5.285% average funds rate predicted
by the futures. Does that mean that the futures are predicting more than a 50 basis-point cut?
That would be great (how do you spell Nasdaq 5000?) -- but it's not very likely. So what are the futures trying to tell us?
They are predicting that for sure the Fed will lower rates by at least 25 basis points between now and the March 20 meeting. Beyond that, they are predicting that for sure the Fed
will lower them by more than 25 basis points at the meeting and/or that it will lower them before the meeting.
If we run the numbers again, using fewer days in March at the existing rate and more days in March at the new lower rate -- which is what would happen if the rate cut occurred
before the meeting -- then we start getting an average funds rate for the month that comes closer to the futures price.
Let's assume that the cut is 25 basis points, but that it will take place Friday, March 2. There would be four days at the existing rate and 27 days at the new low rate that would start
Monday, March 5. That way, the average works out to 5.282%, almost exactly the average baked into the futures price.
Now that's not to say that the futures are predicting exactly a 25 basis-point cut exactly on March 2. We don't know what combination of timing and rate-cut sizes they are predicting
-- there are an infinite number of combinations. But whatever the exact answer, the futures are predicting that some combination of these good things is going to happen for sure.
This is valuable information if it's right -- because it completely flies in the face of the cautious go-slow statements we've heard over the past two weeks from Greenspan and other
Fed officials. And it seems to be turning a blind eye to all the talk about stagflation over the past couple of days.
Piercing the Veil
Are the futures always right? No. But they're the best Fed-watcher I know. And they're all we've got, because the Fed is so secretive.
Why must the Fed operate behind a veil of secrecy? Interest-rate policies get implemented through the open market desk at the New York Fed. That desk is just another trader in
the market -- admittedly one with an awfully big checkbook -- but nonetheless just a trader. And like all traders, sometimes it doesn't want the market to know in advance every move
it's going to make.
For example, one of the most important reasons the Fed lowers the fed funds rate in the first place is to create an incentive for its member banks to bid for more reserves. When the
fed funds rate is lower, reserves are cheaper, and the member banks can get more of them to make more loans with, thus getting lots of lush, liquid money into the economy. But
suppose all of the member banks knew for sure that the Fed was going to lower rates aggressively in the future. The banks wouldn't bid for reserves today -- they'd wait until the
lower rates were put in place and then bid. So instead of making more loans and creating liquidity, they'd make fewer loans while they were waiting, thus reducing liquidity.
This paradox can trap the Fed in a vicious cycle, in which no amount of rate cuts are ever quite enough. David Gitlitz, president and chief economist of DG Capital Advisers (and an
occasional TheStreet.com contributor), was the first Fedophile to identify the dynamics of this vicious cycle. It's the best explanation ever offered by an economist for why
Greenspan never says much, no matter how much he talks.
So listen closely to Greenspan. But you'd probably be better off getting out your calculator and listening to the futures markets instead. |
