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The Swiss Watch of Finance: Where Fed Rate-Cut Odds Come From

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According to CNBC reporting this afternoon, "Traders are pricing in a more than 90% chance of a September rate cut and about 60% probability of three rate cuts this year."

Where do these crazy probabilities come from and how accurate are they at forecasting what the Fed will do -- especially when the economy seems so robust with 4% unemployment and GDP near 3%?

I've tackled these questions a number of times in the past year and since Fed chair Jerome "Jay" Powell just hinted Tuesday in Chicago that he was open to the idea of a rate cut given “trade negotiations and other matters” weighing on economic confidence and inflation, it's worth reviewing the answers because the market reacted strongly in shifting its probabilities.

In fact, the probability of a rate cut at the June meeting in 2 weeks jumped from just 10% a week ago to over 26% yesterday, sending stocks flying higher after a dismal May correction. Even banks like JPMorgan (JPM - Free Report) and Wells Fargo (WFC - Free Report) rallied, when they might be the most hurt by falling rates.

And the probability that the target range for Fed funds will be 25 basis points lower by the July 31 meeting more than doubled from 26.5% to 56.6% today.

In the video that accompanies this article, I show you where these probabilities come from with the CME Group (CME - Free Report) FedWatch tool.

But how important are the Fed Fund futures at predicting what the FOMC actually does? Aren't they just Vegas-style bets like any prediction market, and thus the consensus could be wrong?

Yes and no. Let me explain with a short piece I wrote in March before that highly-anticipated Fed meeting...

The Swiss Watch of Finance

As I explained a few days ago, we went into the FOMC meeting with a big disconnect between what Fed funds futures markets were expecting -- nearly ZERO chance of a hike this year and nearly 40% chance of a CUT -- vs what the last Dot-Plot and what most common sense FOMC economists would say if you ask them.

Here were the notes I gave TD Ameritrade Network before my appearance as a guest on Tuesday March 19...

Why are Fed funds futures markets pricing in ZERO chance of a hike this year?

Won’t there be some big cognitive dissonance when the Dot-Plot shows 1 or 2 hikes still in the cards?

The answer lies in the difference between what equity investors (the pragmatists, not the dreamers) believe about the FOMC (plenty of hawk feathers still on that dove) and how the Fed fund futures actually work.

Fed fund futures are connected (via sophisticated arbitrage) to Eurodollar futures (ED), which are what I call “The Swiss Watch of Finance.”

A Eurodollar is a US buck on deposit in a foreign bank. LIBOR, the London Interbank Offered Rate, is the daily interest rate auction that guides the supply and demand for dollars held overnight in any given bank. LIBOR succeeded “Prime Rate” in the 1970’s as the U.S. short-term interest rate benchmark.

And Eurodollar futures contracts represent the ability to lock-in a 3-month rate on those overseas dollars. In essence, it is a hedging tool for what is occurring with those cash deposits and interbank FRAs (forward rate agreements). Each contract is worth a $1 million notional value and 2-4 million of them trade every day.

That means about $3 trillion worth change hands every day.

Since the early 1980s, ED futures (i.e., LIBOR) have been driven by the forward interest rate yield curves and loan supply/demand exposures of commercial banks (and their corporate hedging customers) in the short-term commercial paper/money markets.

These sophisticated and flexible short-term yield curve tools allow banks to fine-tune their exposures to borrowers, whether corporate or mortgage-related (think ARMs). When their computer models crunch all their assets and liabilities according to "rates and dates" (cost and duration), banks discover gaps and maturity mismatches that they can use ED futures to hedge.

For instance, if Citigroup (C - Free Report) or Bank of America (BAC - Free Report) needs to lock in a 1-year lending or borrowing rates for a term that doesn't begin for 6 months, they have multiple ways to do that with interbank FRAs, FRNs (floating-rate notes), swaps, or ED futures. All are like synthetic loans.

This daily participation from the world's largest banks and corporations -- both lenders and borrowers at any given time -- creates a massively liquid market for determining the supply and demand of short-term money. And these players are predicting what the cost of money (interest rates) will be for different periods in the future because they have to.

Thus, ED futures build forward interest rate curves (but only for 3-month durations) going out 10 years in an elaborate mechanism of precisely-dialed gears and levers for lending and borrowing short-term. In the very near term of one year, it’s also an economic/recession forecast.

And Fed Funds futures simply follow their expert lead on the future price of money.

So the next time you hear somebody say "Oh those Fed funds gamblers don't know what they're doing" you can now educate them that those "gamblers" are trading a sophisticated web of yield curves built on top of a massive Eurodollar market worth over $3 trillion every day.

Bottom line: This “Swiss Watch” has hundreds of precision hedgers who have to bet on money supply/demand, or else. They could be “wrong” about what the Dot-Plot will show, but they prefer to err on not being wrong about what eventually unfolds. With more than 2 full months of economic data to come before Jay & Co. make their July 31 decision, a lot of waves can happen in the Eurodollar and Fed Funds ocean.

To learn more about Eurodollars, LIBOR, and how to use the CME FedWatch tool, be sure to check out the video!

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