The global financial markets are driven by expectations. Traders ask themselves questions like, “How strong is the economy going to be in six months? Are corporate earnings going to be strong? What are interest rates going to look like down the road?” Then they place their trades based on what they expect the answers to these questions to be.
One of the key metrics traders are focusing on right now is expected interest rates. In a recent article we wrote about the concerns investors have that the Fed might start tapering its quantitative easing (QE) program and the impact that is having on stock prices. Now it’s time to look at the market’s expectations for what the Fed is going to do with interest rates in the future.
The Fed has had a zero-interest-rate policy (ZIRP) in place since Dec. 16, 2008, when it dropped the Federal Funds Rate to 0%– 0.25%. We know, it’s hard to believe it has almost been five years of ZIRP, but it has. The question now is, “How long will the Fed keep interest rates at zero? ”
Everyone agrees the Fed will end its quantitative easing programs before it starts to raise rates, but the expectations regarding when the Fed will start raising rates and how quickly it will do so are changing rapidly — which has an impact on the stock market.
So how do we gauge market expectations for when and how quickly the Fed will be raising interest rates in the future? Do we have to conduct surveys to find out what investor sentiment is? Mercifully, we don’t have to do that. There are actually futures contracts that track expectations for the Federal Funds rate, and we can track them as well. The benefit of being able to track an asset instead of a sentiment survey is that traders have to put their money where their mouth is when they buy or sell a futures contract, whereas they can say whatever they want when responding to a survey.
Traders use the 30-day Federal Funds futures contracts to hedge against, or speculate on, potential changes in the Fed’s monetary policy. The price of each contract represents what traders believe the average daily effective Fed Funds rate is going to be for a calendar month. You can see what traders believe the effective Fed Funds rate is going to be by subtracting the price of the contract from 100.
For example, if you click to expand Figure 1 above, you can see that the price of the July 2013 contract is 99.895. If you subtract this number from 100, you will see traders anticipate the effective Fed Funds rate is going to average 0.105% during the month of July. That fits perfectly in the 0%–0.25% range the Fed has set with its ZIRP.
While the near-term futures contracts have been fairly stable for quite some time, investors are starting to get nervous about what they are seeing in the longer-dated futures contracts.
Click to Enlarge As you can see in Figure 2, the expectations for where the Fed Funds rate is going to be in 2016 have changed dramatically.
One month ago, traders thought the Fed Funds rate was barely going to be breaking above 0.5% by 2016. Now, traders are anticipating a Fed Funds rate above 1% — 100% higher than 0.5% — by early 2016 (You can see this illustrated in Figure 1 as the Feb. 2016 contract is the first one to drop below 99). This tells us that the market believes interest rates are going to be rising much more quickly than previously anticipated.
Now, interest rates could be rising because the economy is doing well, but they could also be rising because inflation is heating up, even if the economy is still dragging its feet a bit — similar to what we saw in the late ‘70s and early ‘80s with “stagflation.”
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.