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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 shaped.”

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?

No, 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

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Sources:
Markets Expect Fed Easing? Not So Fast
Real Time Economics, August 1, 2007, 9:50 pm
http://blogs.wsj.com/economics/2007/08/01/markets-expect-fed-easing-not-so-fast/

Fed Keeps Its Focus on Inflation
Rate Cut Seems Unlikely Despite Data Suggesting Increased Risks to Economy
GREG IP
WSJ, August 2, 2007; Page A2
http://online.wsj.com/article/SB118601134105985426.html

Thursday, August 02, 2007 | 07:12 AM | Permalink | Comments (13) | TrackBack (0)
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Comments

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.

Posted by: Econocator | Aug 2, 2007 9:38:00 AM