My Article Disputing Futures Markets' Take on Interest Rates

2008.09.11: Published in Futures Magazine - August 2008
In June-July 2008, most market participants as well as the Fed Funds market expected the Fed to raise interest rates later in the year, placing odds of a September tightening as high as 60%. My position against such market stance was echoed in this article. By September 2008, odds of a 2008 tightening have disappeared.

Fed Funds Futures Could be Wrong

The prolonged increase in U.S. inflation and accompanied decline in the value of the dollar has brought about visible changes in the rhetoric of Federal Reserve officials, to the extent of triggering aggressive sell-off in Fed funds futures contracts. In March the contract anticipated continued easing to 1.5% and at one point in mid June the December contract traded to 9719, an indication of more aggressive tightening.

As U.S. annual inflation held up above 4.0% in spring 2008, with successive records in oil prices showing little signs of dissipating, the Fed has taken matters in its own hands by changing tack. By upgrading its inflation preoccupation at the April and June FOMC meetings, the Fed has made it clear that containing inflationary pressures is its main policy priority, rather than shoring up weak economic growth. At one point in June, Fed funds contracts were pricing a 100% chance of a rate hike by end of the year, at a time when unemployment, housing and manufacturing were deteriorating to levels typical of a recession. Are futures traders getting too ahead of themselves? Or is the Fed wrong in shifting its focus? Will they really commit to fighting inflation in the face of a weak equity market.

Nervousness with inflation extended beyond the Fed and onto most central banks in the industrialized and developing world. For the U.S. central bank, the problem is compounded by the falling dollar. The Fed cannot anchor inflation expectations effectively without a stable dollar. The rest of the world also realized the importance of stabilizing the damaged U.S. currency in order to alleviate the problem of soaring food and energy prices.

On June 3 Fed Chairman Ben Bernanke shook the currency market by taking the unusual step of talking up the dollar. Hardly two days elapsed after what seemed to have been a historic speech, the dollar recovery was quickly eroded by the fundamental realities of the U.S. and global economy. European Central Bank president Jean-Claude Trichet hit the wires signaling a July rate hike as Eurozone inflation surged to twice the level the ECBs mandated maximum. The euro surged across the board, sending the dollar lower against most European currencies. The dollar eventually lost all of its post-Bernanke gains when the U.S labor report showed the unemployment rate jumping to 5.5% from 5.0% and payrolls posted their fifth consecutive monthly decline. On the same day, the dollars decline accelerated after an Israeli official said an attack on Iran was "imminent", prompting a record $10 increase in the price of oil.

The dollar sustained renewed pressure in the rest of June amid reemerging cracks in the capital structure of U.S. banks, and renewed deterioration in employment, housing, industrial production and consumer confidence. As a result, the Dow Jones Industrials Index and the S&P500 responded by intensifying their declines to reach three- and two-year lows, falling 20% from their October record highs. Although Fed funds futures had lowered expectations of a 25-bp rate hike by year-end from a 100% probability, odds remain as much as 75% of similar tightening by year-end. Such pricing seems flawed considering the historic pattern showing the Fed to have never raised rates without a considerable decline in the unemployment rate off its cyclical peak. With the unemployment rate firmly standing at a four-year high of 5.5%, and with every labor market indicator pointing to further deterioration ahead, a Fed hike would be a grave economic blunder. The spread between 10 and two-year yields shows a renewed steepening in the yield curve, suggesting prolonged strains in the financial system and weakness in the overall economy leading to a resumption of the easing cycle.

Traders must realize that the calculated probability of interest rate decisions is derived from the price and effective yields of these contracts, which are in function of traders reactions to economic reports and Federal Reserve speeches. But lately, its been more a case of hawkish speeches than improved data. Since central banks managing of inflation expectations are vital to controlling actual inflation, the Fed hopes to support bond yields and stabilize the dollar via controlling the bond markets expectations of inflation. The main risk to this strategy is that excessive strengthening in bond yields remains disjoined by deteriorating market and economic fundamentals. Despite the Feds tough inflation talk, we expect the next move in interest rates to be a decrease of 25 bps to 1.75% in October, with a likely subsequent reduction in December to 1.50%.

This analysis would support buying an October or further out Fed Fund futures at its current price. Another and perhaps safer strategy would be a spread. In July Fed Funds futures priced in a higher likelihood of a tightening by December than October, while our analysis indicates a higher likelihood of further easing by yearend. One could buy the December contract and sell the October or November contract. This would reduce your margin cost and work if we are right or if the Fed just remain on the sideline.

Ashraf Laidi is Chief FX Strategist at CMC Markets and author of Currency Trading and Intermarket Analysis: How to Profit from the Shifting Currents in Global Markets Wiley Trading.