What Are Fed Fund Futures Actually Forecasting?

Fascinating discussion on the meaning of the Fed Fund Futures. While many economists have taken to stating this means a likely rate cut before the end of the year, some look at it quite differently:

"Lou Crandall, chief economist at Wrightson Associates, says while such action is commonly attributed to increased expectations of a Federal Reserve rate
cut, that would be a mistake. The real reason, he said, is that
investors are fleeing risk and seeking safety in Treasury bonds and
bills and other high-quality paper, sending their prices up and yields
down. As a result, the entire yield curve has shifted down. To maintain
parity with that lower yield curve, the implied federal funds rate also
has to drop, he says.

Mr. Crandall says, “99% of the universe,
including a lot of people in those trades, don’t do it because they
think the Fed will ease but because that’s the way the yield curve is

But wait a minute: isn’t that a violation of efficient
markets? If fed funds futures were out of line with a realistic
expectation of Fed action, couldn’t smart people take positions in the
mispriced futures and make a bundle six months later when it turns out
the Fed didn’t cut rates? And shouldn’t such arbitrage push
expectations of the Fed and pricing of futures back into line?

says Mr. Crandall, for two reasons. First, the Fed has gotten more
predictable but gives no guarantees on where rates will go, so there is
no assured profit on such a trade (so it wouldn’t really be arbitrage).
Second, “The amount of money backing people who have opinions about
where the Fed will be in six or nine months is dwarfed by the amount of
real money being invested in short-term credit markets.” Nervous
investors are willing to accept a lower yield than what might
ordinarily be justified based on the economics in exchange “for safety.
Market participants know that perfectly well. That’s why it’s called a
flight to quality.”

That makes good sense to this disbeliever in the efficient market hypothesis . . .


graphic courtesy of WSJ.com


Markets Expect Fed Easing? Not So Fast
Real Time Economics, August 1, 2007, 9:50 pm

Fed Keeps Its Focus on Inflation
Rate Cut Seems Unlikely Despite Data Suggesting Increased Risks to Economy
WSJ, August 2, 2007; Page A2

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What's been said:

Discussions found on the web:
  1. Econocator commented on Aug 2

    I don’t believe in EMH in the strict sense, and I also believe the market may be overly pessimistic with respect to the implied forecast for the Fed Funds rate. However, I am struggling to t buy into Lou’s notion that recent may signal something other than increased expectations of rate cuts from the Fed.

    ‘To maintain parity with that lower yield curve, the implied federal funds rate also has to drop’

    – The yield curve has previously exhibited kinks, rising or falling at the short end and doing the opposite further out. This suggests the implied Fed Funds rate doesn’t need to maintain a ‘parity’.

    ‘… the Fed has gotten more predictable but gives no guarantees on where rates will go, so there is no assured profit on such a trade (so it wouldn’t really be arbitrage).’

    If we agreed that, for various reasons, that the Fed futures gave a false forecast of Fed rates, in theory it could follow a random walk and so it couldn’t be arbitragued. However, Lou seems to be saying that the implied forecast has overshot due to increased risk-aversion flows; over time, even though there is no assured profit, you could still trade on the notion that the price will tend toward the true Fed funds forecast over time. This assumes you believe the implied forecasts are wrong in the first place.

  2. The Financial Philosopher commented on Aug 2

    Thanks for the observation, Barry. I’m not much of an economist. Is this consistent with the phrase, “Don’t fight the Fed?” Or is it time for a new phrase? How about “Don’t fret the Fed” or “Don’t forecast the Fed.” I imagine someone more clever than I can think of a phrase more fitting.

  3. michael schumacher commented on Aug 2

    I think that is just a useless piece of information as it basically is used to telegraph whatever the big institutions expect out of the fed. If you ask 5 people you’ll get 5 different answers. It is an indicator that has it’s basis in expectation only not any tangible result. And if you were asked if you expected or wanted cheaper money would’nt you answer yes as well?

    I know I would….but to use it as some sort of plausible indication??….sorry it’s not even worth the paper that they may or may not print it on.


  4. KP commented on Aug 2

    Blah…expectations != reality.

    Arbitrage opportunities really stems from deviations between the two.

  5. Woodshedder commented on Aug 2

    MS- still doing some checking on that treasury auctions. Did you mention that GS was buying them, or did I dream that?

    I can’t seem to find any way to be able to tell who won the auctions.

  6. michael schumacher commented on Aug 2

    I’m not really interested in the outcome….just that it’s being done in those increments in a short time frame.

    It’s there….just gotta look.


  7. costa commented on Aug 2

    MS what is that website again as well?

  8. UrbanDigs commented on Aug 2

    there is just very litle chance of fed cutting rates given:

    1. strong labor market
    2. global growth/inflation
    3. high energy prices
    4. globally hawkish central banks raising rates
    5. weak us dollar

    Last November, there was consensus predicting rate cuts for early 2007, and its no surprise that didnt occur. Fed is just caught in tough spot now and rate cuts and more liquidity just seems a very dangerous move.

    In addition, this credit correction and repricing of risk is doing the fed a favor as markets correct themselves and this is a healthy thing knowing the root cause. Lets see if markets can absorb this and whether or not the hole ends up being much deeper than everyone thinks. It seems global liquidity might be able to handle this, but its still a much different world than years of ultra liquidity we got used to.

  9. Eclectic commented on Aug 3

    Well, Mr. Crandall, thanks for explaining to Barringo why he gets to do the cluck, cluck, cluck after last day 2007.

  10. I’ll take that action commented on Aug 3

    I’m still not understanding why a person couldn’t make money betting now that the Fed fuind rate WON’T fall on Dec 11th?

  11. stan jonas commented on Aug 5

    Of course you can make money..
    Here are the odds… you can click on your computer and make this “bet” on the Chicago Board of Trade tomorrow:..

    Fed Ease by December… that’s yesterday’s news..

    You can buy a put for 65 dollars.. if the FED either is on hold or eases just ONCE by December your 65 dollars makes you 35 dollars..

    Or flipped around.. if you pay 35 dollars today.. you will get back 100$ if and only if the FED eases twice by December.

    Want a simpler bet.. and the one that the FED looks at… Roughly 60% probability that the FED will just ease 25 by December…

    For those more adventure and with a shorter attention span..

    The probability trading in the marketplace that the FED eases at the August FOMC.. next week is close to 15%…


  12. Wuang Lee commented on Aug 23

    I am not an economist. I dont know why FED use the interest rate of FED FUND to control the inlfation of (GAS/OIL price). I feel it is not a perfect tool. I see the OIL Price countinue going up by times. OIL price have been control by such a few largest corporations. They have been dominating the OIL Market, both export and import.
    Whenever FED RATE been raising, CONSUMER been hurting.

    Thank you,


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