Tuesday, August 21, 2007

Will the Fed Cut Rates? How To Estimate Odds

Everyone is on Fed Watch. People are wondering whether the Fed will cut rates or not. Can we figure out the direction of interest rates?

We can.

The Chicago Board of Trade has an instrument called the 30 day Fed Funds Futures Contract. By looking at the prices of these Futures, we can better estimate the odds.

Getting Information about the Fed Funds Futures Contract

Here's the Current Chicago Board of Trade 30 day Fed Funds Future Contract.

We can also use FutureSource.com's Fed Funds Futures Quotes.

As of this moment, using FutureSource.com's quotes, September 7, 2007 shows 95.13 and October 7, 2007 shows 95.225. What you do is subtract that number from 100. September 7, 2007 will have the value (100-95.13) = 4.87% and October 7, 2007 has the value (100-95.225) = 4.775%. This is called the implied Fed Funds Rate on the Futures Contract.

The Current Fed Funds Rate is 5.25%. And since there is no September 7, 2007 meeting, it is better to look at the October 7, 2007 contract instead. So by October, the implied interest rate is 4.775%, so rate cuts are likely.

The next two Fed meetings are on 9/18/2007 and 10/30-31/2007.

How do you calculate probabilities?

There's a financial calculator online to help calculate probabilities:
Fed Funds Calculator

Rate Cut Probabilities on September 18, 2007 meeting

Using this calculator, and using the October 7, 2007 contract, we enter these values:

  1. 30 Day Federal Funds: 95.225
  2. Current Federal Funds Rate: 5.25%

With the numbers above, the Implied Interest Rate is 4.78% (by calculating 100-95.225).

If we enter the Expected Rate of 5.25% (no change)

In this scenario, the odds of rate cuts are:
1. 5.00% (0.25% cut): 190%
2. 4.75% (0.50% cut): 95%

So the market appears to be pricing in almost certainty that the Fed will cut either in September 2007 and further cuts after that are also almost certain.

As the Fed Fund Future changes, you can follow the process above to determine future probabilities.

More information on calculating Fed Funds:

1. Tony Crescenzi (RealMoney.com Contributor) article on Tracking The Market's Fed Expectations.

2. Cleveland Fed's Frequently Asked Question on Fed Funds Futures.

3. Chicago Board of Trade Fed Watch Page.

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