Calculating the Fed Funds Futures

US measures of core inflation fell from February through May. 
The US reports June CPI at the end of the week.  There is a reasonable
chance that the core rate stabilizes.  However, the movement away
from the target has spurred expressions of caution from numerous Fed officials,
even though the minutes of the June FOMC meeting showed that most officials
recognized transitory factors weighed on prices.  

A careful reading of Fed comments led us to conclude that a consensus on
reducing the balance sheet was intact, though a consensus for another hike may
prove more difficult until there is more evidence for the official
Hence we look for the FOMC meeting in a fortnight to only
modestly tweak the statement.  In September we expect the Fed to announce
that it will begin implementing its strategy to
gradually reduce its balance sheet starting in October
.  Depending
on the evolution of the economy and inflation, a third rate hike for the year
could be delivered in

For the same of this exercise, let’s assume that there is no chance of a
hike before December.
  No chance may exaggerate it a bit, but probably
not very much and it makes for a simpler exercise.  Fed funds would likely
trade around current levels, which is 116 bp on an average effective
basis.  This is what is averages for
the first 12 days of December.  On December 12, if the Fed were to hike
rates, we should assume that the new effective average would by 25 bp higher or
141 bp.  

That average could last 16 days to Friday,
December 29
.  The effective average rate for the last trading day of
the year typically falls post-crisis.  Last year it fell by 11 bp. 
If we assume that the effective rate does the same thing this year, and
recognizing that the Dec 29 effective average rate is the same for December 20
and 31, the weekend, Fed funds average 130 bp for the last three days of the
month.  When you do the math with
these points, the outcome is an average of 130.25 bp for the month.  

To conclude the exercise, recall that on no change in policy, the
effective average rate should be what is today 116 bp.
  On a 25 bp
rate hike, fair value is 130 bp.  Currently, the Dec Fed funds contract is
yielding 124.5 bp, or 8.5 bp of a possible 14 bp or about a 60%

Another debate that appears to be intensifying among officials and
investors is the relationship between reducing the Fed’s balance sheet and
  We have always been skeptical that a certain change of
the balance sheet is tantamount to change in interest rates.  
Leaving aside economic theory for this unprecedented policy course and looking
simply at what happened under QE, it appears that the anticipation and signaling effect was what spurred the decline
in yields more than the actual buying.  This
seemed to be the conclusion of the ECB’s experience as well.   

The impact of QE and the buying and holding will be the subject of white
papers and dissertations, but it is not clear gradually reducing the number of Treasuries and MBS securities being allowed to run-off will have a substantial impact
.  It is true that
the bonds that the Federal Reserve has been buying needs to be replaced by
other economic participants.  However, buying by financial institutions,
households and the vast cash held by corporations, not to mention foreign
investors, remains strong, which is why bond yields are lower now than when the
Fed hiked last December or in March.  Also,
as we have noted, the US Treasury has recommended changes in the calculation of
the leverage ratios, which would reduce the funding costs of Treasury holdings
by banks.  

There are two main thoughts about why interest rates are low. 
The consensus view emphasizes central banks activity.  In our work, we
have tended to lay more weight on slow growth, low inflation, and the surplus
capital.  The consensus argument lends itself to expecting interest rates
to rise as the central bank’s withdraw from their extraordinary measures. 
However, stronger economic data and firmer price pressures encourage central
banks to normalize policy.    We note the secular decline in US
bond yields since 1981 and the low point was reached not during QE, but after
QE had ended and a gradual monetary
tightening cycle had begun (July 2016, 1.32% for the 10-year note).  


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