Why Fed Funds Futures Might Not Reflect Fed Expectations

If you want to play around with short-term credit in the futures market, there

are lots of ways of doing that. On the other hand, if you want to express an

opinion on where the Fed funds rate is going to be at some point in the future,

there’s a very specific way of doing that: Fed funds futures. So to

get an idea of where the market thinks that the Fed is going to be in six or

nine months, all you need to do is look at the Fed funds futures contract. Right?

Maybe

not, says Lou Crandall, quoted today by the WSJ (via Barry Ritholtz).

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…

“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.”

This does make a certain amount of sense. After all, no one thinks that currency

futures reflect where the market "thinks" a certain currency will

be trading at some point in the future: everybody knows that they reflect nothing

more than interest-rate differentials between two different currencies.

And it also helps explain why the market was "pricing in two rate cuts

by year-end" even when precious few economic forecasters were predicting

such a thing.

But I’m still not clear on why people would use Fed funds futures, specifically,

to lock in future returns.

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