Fed funds as indicator?

Discussions about the psychology of the markets and the masses as it relates to trading.
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K1
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Fed funds as indicator?

Post by K1 » Fri Oct 01, 2004 4:55 am

Bush Will Win It
By Dr. Steve Sjuggerud
President, Investment U

John Kerry has his work cut out for him tonight in the debates. Judging by the futures market, where real money is on the line, John Kerry doesn't stand much of a chance to win this election...

This is a big change from a month ago, based on the futures markets (ignoring the polls and the evening news) - which actually do accept bets on the presidential race. Let me explain what I'm looking at, and why it's so valuable...


How To See the Future

When people ask me about what the interest rates will be next year, I don't get sucked into making a prediction... Predictions by economists about things like interest rates, inflation and economic growth are pretty worthless. I don't want to see a poll of economists any more than a poll of potential voters. The reality is, nobody knows the future.

However, there is one decent predictor of value, or at least one better than polls... and that is in the futures markets. Why? Futures markets reflect all bets right now, based on real money on the line - in the case of interest rates for example, it's $5 million per futures contract, to play. It's real money.

Let's take a look at how to use the futures markets... For example, will Alan Greenspan raise short-term interest rates from their current level of 1.75% to 2% by the December 14 Fed meeting? The answer is yes... Based on the Fed funds futures, there is a 100% chance that Alan Greenspan will raise rates by at least a quarter of a percent by the December Fed meeting. Something major may happen between now and then, but the players in the futures market are pretty darned confident here.

The next Fed meeting after December is early February. And there is an excellent chance that Greenspan will raise rates again at that meeting, based on the Fed funds futures. So there is an excellent chance short-term rates will be at least 2.25% by the end of the Fed meeting in February. Again, it's not guaranteed, but the folks with real money on the line like their odds. They're betting on it.

You can find the Fed funds futures numbers at the Chicago Board of Trade website (http://www.cbot.com). (To get the interest rate, subtract the number shown on the website from 100). Again, right now, the Fed funds future contracts for early next year imply two rate hikes by the Fed through February.

Remember, one Fed funds futures contract controls $5 million. So people making these bets had better be pretty confident in what they're doing. What we're assuming is that the collective sum of buys and sells... of bets for and against... cancel each other out and give us a pretty good guess of future rates. So don't bother with the polls. Follow the money. Just look at the Fed funds futures (www.cbot.com).


How Accurate Are Fed Funds Futures At Predicting The Fed Funds Rate?

You'd be surprised. The Fed actually did a study of this, and the relationship is pretty good, with a caveat that the Fed funds futures rate is a little overpriced. (The Fed studied Fed Fund futures from 1989 to 2001, and said, "If someone wants to make an educated guess as to what the fed funds rate will be in four months, he should subtract 0.187 percent from the current four-month fed funds futures rate.")

Here's the report from the Fed (Adobe PDF format):
http://www.clevelandfed.org/Research/Com2001/1001.pdf

As you'll see from that report, the Fed funds rate is not a perfect predictor. You don't want to trade off of it. But as the chart on page 3 of that report shows, it's as solid an indicator of future short-term rates as you'll find.


Why John Kerry Will Almost Certainly Lose

Just like there is a futures market for interest rates, there is also a futures market for the presidential election.

For a while, the race was very close. Just a month ago, it was deadlocked... 50/50.



Source: http://www.biz.uiowa.edu/iem/

But over the last month, George Bush has pulled away. The way the futures contract on Bush works is "$1 if the Republican Party nominee receives the most popular votes in the 2004 U.S. Presidential election, $0 otherwise."

The Bush contract is at about 67 cents now. While the Kerry contract is at about 33 cents. That means if you bet 67 cents on Bush today, and he wins, you'll get $1 on November 6. Same for the Kerry contract... if you bet 33 cents on Kerry today, and he wins, you'll get a dollar for every 33 cents you bet.

The presidential elections futures market is run by the faculty at the University of Iowa. No joke. And the results have been no joke either. According to Lawrence Kudlow, "From 1988 to 2000, the IEM was off just 1.37 percent in its election-eve prices for presidential elections. If this doesn't prove that crowds and market wisdom are usually more accurate than expert pollsters or any media elite, I don't know what does."

It's not just the Iowa futures markets. The online gaming places have the same odds. For example, Bush is currently at 68 cents while Kerry is at 32 cents at http://www.TradeSports.com.

If Kerry is going to win, he's really going to have to do something extraordinary. The futures markets - people putting real money on the line - have placed their bets. And their bet is Bush.

Fed funds futures contracts are useful at looking at the future of interest rates, but they don't extend that far into the future. Fortunately, Eurodollar contracts do. Eurodollar contracts represent a widely traded interest rate guess. You can track estimated short-term interest rates here, for a long way into the future.

Eurodollar rates are slightly higher than Fed funds rates. Below are the interest rates for the current Eurodollar futures contracts. As you can see, the Eurodollar contracts are pricing in approximately a 50 basis point rise in interest rates from now until March '05, same as the Fed funds futures.

It is interesting to note that by March '06 short-term interest rates may rise by another full percentage point (from 2.5% to 3.5% on the Eurodollar futures), and then rise another half a percentage point again by March of '07.

Euro$ Contract Rate
OCT04 2.09
MAR05 2.57
SEP05 3.05
MAR06 3.51
SEP06 3.84
MAR07 4.09

This is really getting into guessing land now. Forecasting reliability obviously becomes an issue the further into the future you go. About the best you can reliably say is that the market expects short-term interest rates to rise significantly in the coming years.

efficiency
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Post by efficiency » Mon Jan 22, 2007 8:13 am

Banks don't borrow from the Fed Funds window. They borrow from correspondents or overnight repo's.

I will concede Prime is pegged to Fed Funds. Moral suasion.

Bit of a contradiction when Fed Funds has consecutive hikes but open market operations are buying up T-issues from banks, thus fostering lending and hence liquidity in the economy. Multiplier effect a/ka/ velocity.

Left hand. Right hand.

BARLI
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Post by BARLI » Mon Jan 22, 2007 3:24 pm

efficiency has a banking background 8)

Jimbo
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Post by Jimbo » Wed Jan 24, 2007 10:41 am

efficiency wrote:Banks don't borrow from the Fed Funds window. They borrow from correspondents or overnight repo's.
There is no "fed funds window" - and the interest rate charged by the correspondents and repos is pretty much directly determined by the target rate set by the Fed and enforced through open market operations. So I don't quite get what your saying, here...

efficiency
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Post by efficiency » Fri Jan 26, 2007 3:51 pm

Jimbo wrote:
efficiency wrote:Banks don't borrow from the Fed Funds window. They borrow from correspondents or overnight repo's.
There is no "fed funds window" - and the interest rate charged by the correspondents and repos is pretty much directly determined by the target rate set by the Fed and enforced through open market operations. So I don't quite get what your saying, here...
Open market operations isn't "enforcing" except as a by-product. Well, T-issues can and do serve as reserves for loan losses. But then, so do quasi mortgage-backed securities. OMO is the injection or withdrawl of liquidity. Unfortunately much more of the former. Almost secular credit expansion.

There are times, though not recently, when overnight repo's can be in double digits for a day or so. Abberations. Didn't look, but I imagine the New Orleans hurricane caused a blip.

Left hand: Interest rates Right hand: Liquidity

The economy funk shuns on liquidity. Rates, for a lack of a better term, is the speed limit. The focal point "rent" on money. The amount extended can be highly variable.

Southwest Bank in St. Louis is generally the first to raise Prime in response to Fed Funds hikes. Money centers follow. Still ......moral suasion. There are some customers that borrow below prime. One example would be Boys Town here in Omaha. But..........they have $35 million on the balance sheet

Fed only directly impacts the short end of the yield curve. It has some indirect impact, particularly when other govt. branches cite jobs created, beneign inflation, and other bogus stats. Foreign capital dependency is beyond the scope of this thread.

The point is, Fed Funds isn't a viable indicator for much of anything, particularly trading.

Simply put, (17) consecutive Fed Fund hikes yet concurrent bull markets in equites and commodites. Not the logical response to tighter money (and higher "tax" on earnings).

efficiency
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Post by efficiency » Sun Oct 26, 2008 7:23 pm

I stand slightly corrected. The majority of banks don't borrow Fed Funds. They rely on upline correspondents (both borrowing and loan participations beyond legal lending limits) or repurchases from often unknown counter-parties.

It would however appear, that money center banks do. Particularly in times of crisis.

"letting Lehman go" was apparently under-estimated by Henry, call me Hank, Paulson. Aka Hanky Panky

Chart attached.

Heart murmur???
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