Last week’s hawkish Federal Reserve guidance sent the front end of the yield curve for a tailspin. In the process, the odds of a March hike went from less than 50% to almost 100%.
The movement in the Fed funds futures curve was swift and vicious. The whole curve shifted higher (in terms of yield), but the April future backed up the most.
When examining the Fed funds futures market it is important to remember contracts are cash settled against the average effective Fed funds rate for the entire month. The current upper target for Fed funds is 0.75% and the lower target 0.50%, so in theory, if the rate was not changed, the futures should be worth approximately 99.37 (100 – midpoint between 0.50 and 0.75). It’s not quite that easy as Fed funds can still trade anywhere within that band, so it is difficult to nail down with precision exact odds regarding market expectations.
The other important point to remember is that Fed funds futures settle based on the average rate over the entire month. Therefore trading March futures is not the “cleanest” way to express a view on the chance for a March hike. The April expiry, which has no FOMC meetings within its averaging period, is much better.
When we look at the chart for the Fed funds future April expiry, the amount of repricing that occurred last week from all the Fed rhetoric becomes clear.
Remember the “theoretical” price for the future before a rate hike is approximately 99.37. If we assume the Fed will raise rates by 25 bps, then April should be worth about 99.12. Now I realize the effective rate for Fed funds has been trading on the higher side of the midpoint for the recent past, but my back of the envelope calculations are close enough.
At the current price, the April Fed Funds future has almost a 100% chance built in for a March hike.
A couple of weeks ago when the market was pricing in less than a 45% chance for a March hike. It is now clear that at that point, the market was underestimating the Fed’s propensity to raise rates. Getting short Fed funds futures was a great trade.
But now, with almost 100% chance of a hike in the price for the April future, it makes no sense to short. And in fact, it is probably worth a punt on the long side.
Now don’t misconstrue this statement as a forecast the Fed will not hike next week. A March hike is by far and away the most probable outcome.
Yet, the risk reward from a long position in the April expiry still makes sense.
The all-important US employment report is due out this Friday. Most likely it will not derail the Fed’s path, but the chances of an accident are probably higher than the market is pricing in. Yes, it would be a fail of epic proportions if the Fed was forced to backtrack their guidance due to a soft employment report, but it’s not like they haven’t been embarrassed before due to incorrect signals.
If everything turns out as expected, I don’t think you lose much being long the April Fed Funds future. But if there is a surprise, it could turn out to be a decent little winner. After all, if there’s anything we should have learned over the past few years, it is that anything can happen.