Fed Futures on the Fed’s Future
What the market is telling us
On July 11th the Fed Funds Futures market jolted with excitement. On that day, the implied probability of the Federal Reserve lowering its target interest rate changed dramatically. The chance that the Fed’s target interest rate will be as low as 4.5 percent come December (down from its current 5.25 percent) increased from about 25 percent to 45 percent.
Why is this change in probability notable? Well, it was only less than a month ago that the Fed pessimistically changed its own forecast—suggesting only one rate cut was coming for the remainder of this year.
Now, however, according to traders in the Fed Funds Futures market, there is about a 50 percent chance of seeing the Fed’s target rate fall by 75 basis points (0.75%) by the end of this year.
What titillated the Fed Funds Futures market so?
Disinflation!
On July 11th the Bureau of Labor Statistics (BLS) released the inflation rate for the month of June, as measured by the Consumer Price Index (CPI). Figure 1 displays two versions of the CPI (all items and all items minus food and energy) over the 12 months spanning May 2023 to June 2024.
Guess what? During the month of June, inflation was actually negative, falling by 0.6 percent, or about 0.7 percent on an annualized basis. Also, inflation measured by the index excluding food and energy increased by less than 0.1 percent (about 0.06 percent), which amounted to an annualized increase of 0.8 percent. As can be seen on Figure 1, both indexes have averaged much lower rates of inflation the past 12 months compared to the previous couple of years. Both indexes, too, have been trending downward since February.
This is all good news and this is way the Fed Funds Futures market changed quickly.
Fed Funds Futures
What are Fed Funds Futures exactly? And why does this market matter?
Fed Funds Futures are futures contracts that allow investors/traders to lock-in an interest rate (see here or here for detailed overviews). Traders use Fed Funds Futures to either hedge against an unexpected change in the federal funds rate, or to make a bet on a future change in the rate. Fed Funds Futures are traded on the Chicago Mercantile Exchange; the market is very liquid, with contracts trading daily.
For Macroenthusiasts and Fed-watchers, the Fed Funds Futures market provides a way to see what traders and/or investors think the Fed is going to do at future meetings. These futures contracts, in a sense, provide a “crowd-sourced” daily forecast of future changes in the federal funds rate.
For example, Table 1 displays daily implied probabilities of a change to the Fed’s target level for the Federal Funds rate at the December 2024 meeting. Table 1 shows the probabilities from July 10th (the day prior to the BLS’s CPI update) up through July 24th. The column headers identify the range for the federal funds rate target, where “525-550” identifies the current target range of 5.25 to 5.5 percent.
Notice the first two days in the table highlighted in blue, and values in three of the columns bolded for emphasis.
First, notice first row of the last column in the table. On July 10th traders were pretty confident that the Fed’s target rate would be lower than the current 5.25-5.50 range; there was only a three percent chance of the target rate remaining at its current level. On July 11th that dropped to zero percent and has remained at zero since.
The fourth column reveals the excitement I alluded to at the outset of this post. From the 10th to the 11th, the chance of the rate getting down to 5 percent (a 25-basis point cut) fell from 23 percent to 8 percent. By the 24th, that was down to 3 percent. In other words, traders now expect a bigger cut.
Indeed, from the 10th to the 11th, the chance of the Fed cutting its target rate by 75 basis points (by the December meeting), jumped from 26 percent to 46 percent on the 11th. By the 24th, that was up to 53 percent!
What will the Fed do next week?
While the July 11th CPI report and the Fed Funds Future data are intriguing, neither imply the Fed is going to do something next week.1 Jerome Powell & Co. are still likely to continue to bide their time in order to make sure inflation continues to trend downward.
Traders in the Fed Funds futures market, however, are now at least more optimistic than the Fed itself was a month ago.
In fact, the implied probabilities from Fed Funds Future data for next week’s meeting suggest traders think there is little chance of a change (only a 6 percent as of July 24th , which is actually lower than a 9 percent chance on July 10th). To see the daily probabilities, go to https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html. From there, one is able to download a .csv file with the daily values.