A Forex View From Afar

The (un)Usefulness of Fed Funds Futures

When someone wants to gauge the market’s sentiment for the Fed Funds rate there are two big choices: take a simple look at the Fed Funds Futures, or extract the probability from the bond market, which is somewhat more complicated because it usually includes a premium.

However, these days, the Fed Funds Futures market is totally hopeless. Why? The answer is simple, but we need to first explain how the Fed works.

The Fed sets its Targeted Rate in the eight FOMC meetings scheduled throughout the year. The Targeted Rate is only a target for the overnight interbanking rate. In normal market conditions, the effective rate, the real banking rate, usually swings in close proximity to the targeted rate. But lately, this has not been the case.

In the last few weeks, the Fed has silently adopted a quantitative easing policy, the effective rate has literally plummeted to zero. For example, in the last two days, the effective rate was set at 0.12%, way under the 1% benchmark.

The Fed Funds Futures market tracks the effective rate, not the Targeted Rate, so, because the Fed lets the effective rate swing wild, the Fed Funds Futures have lost their ability to track the Fed’s next move. This will probably remain as such until the Fed decides to bring back the effective rate near the targeted rate.

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