Understanding Fed Funds Futures
Traders can buy and sell futures based on the fed funds rate and their expectations for changes in that rate. When traders think that the Fed will raise rates in the future, they sell these futures contracts, and when traders think that the Fed will lower rates in the future, they buy these futures contracts. These contracts are a great way for institutional traders to hedge interest-rate risk and speculate on changes in the future.
The fed funds futures rate can be useful for Forex traders who are looking to understand what market expectations for the longterm trend are. If the fed funds futures rate were to show a rate that is lower than the current rate, it would indicate that traders are expecting a rate cut, which would typically be bad for the U.S. dollar. Conversely, if the fed funds futures rate were to show a rate that is higher than the current rate, it would indicate that traders are expecting a rate hike, which would typically be good for the U.S. dollar.
If you are used to trading other futures contracts, the way these fed funds futures are priced can be a little confusing at first. The calculation for the price is 100 minus the expected fed funds rate. For instance, if the current price is 96, then you know that traders expect the fed funds rate to be 4 percent (100 – 4 = 96).
Similarly, if the fed funds futures rate rises from 96 to 98, then it shows that traders believe that the rate will change from 4 percent (100 – 4 = 96) to 2 percent (100 – 2 = 98). These kinds of moves happen over the long term, of course, and the fed funds futures rate can channel in a very tight range for a long time.
It is important to remember that the fed funds futures chart is showing what traders think will happen to the rate in the near future, not what it is right now. The fed funds futures chart is something that analysts and traders will refer to frequently, and it can be a great resource when you are trying to understand where interest rates are likely to go. You can find the fed funds futures chart at the Web site for the CME. There is also a great discussion of the predictive power of options on the fed funds futures at the Web site of the Cleveland Federal Reserve.
So what should you be watching for when you analyze the fed funds futures rate? You should be looking for the following:
- When the rate starts to rise, look for the U.S. dollar to lose value.
- When the rate starts to fall, look for the U.S. dollar to gain value.