Today the FOMC meets after last week’s 75bp emergency rate cut. My thoughts? They have to cut 25bp. A no cut would result in the markets collapsing while a 50bp cut would limit their hands even more so than they are now. And it’s probably time the FOMC took control of who decides when to cut rates and by how much. The markets the past few meetings have been dictating how much to cut and any disappointment from that results in a huge sell off. Look at what happened mid-December.
The markets are currently pricing in a 25bp cut with the potential for a 50bp cut. So how do you figure out what the percentage is? First, here’s a link to the CBOT – Fed Funds 30 Day Futures table. For this exercise, we’ll look at January and February.
- January futures: 96.07
- February futures: 96.945
The first thing you need to do is figure out what the predicted FF rate is. Simply subtract 100 from the current futures price to calculate what the markets are thinking the FF rates will be by the time those futures expire.
- January Predicted FF Rate: 100-96.07 = 3.93
- February Predicted FF Rate: 100-96.945 = 3.055
Aha! Some reasonable numbers. Now we know for the most part the Fed cuts rates in quarter increments. So what’s going on with these odd decimal values? Remember that these futures predict the change in the interest rate by the expiration of that month’s futures. So in order to determine what the markets are predicting, we need to know what the interest rate was prior to that month’s expiration.
- FF Interest Rate Prior to January’s expiration: 4.25%
- FF Interest Rate Prior to February’s expiration: 3.5%
What? Why are the two rates different? Remember that at the last FOMC meeting, the Fed brought rates down to 4.25%. Last week, the Fed held an emergency meeting cutting rates to 3.5%. Since January’s futures were already in play, you must use the interest rate prior to that starting month.
So how do you figure what the markets are “baking” in? Let’s take a look at January’s probability first.
- January Current Rate – Predicted Rate = 4.25 – 3.93 = 0.32
Now that we have the difference, how do we calculate what the markets are predicting? Here’s a quick conversion rate on how to determine what the markets are pricing in:
- 25 basis point cut: multiply current – predicted by 4
- 50 basis point cut: multiply current – predicted by 2
- 75 basis point cut: multiply current – predicted by 1
- 100 basis point cut: multiply current – predicted by 0.5
So now let’s multiply the basis point predictions by our 0.32 difference:
- 25 basis point cut: .32*4 = 1.28 or 128%
- 50 basis point cut: .32*2 = .64 or 64%
As you can see, the markets were predicting an over 100% chance of a 25 basis point cut this Fed meeting with the possibility of a 50 basis point cut. Obviously, we’ve gotten that as a result of the emergency rate cut, so let’s look at February’s futures prices to determine what the Fed will do before then.
- Current rate of 3.5 – Predicted value of 3.055 = 0.445
- 25 basis point cut: 0.445 * 4 = 1.78 or 178%
- 50 basis point cut: 0.445 * 2 = 0.89 or 89%
- 75 basis point cut: 0.445 * 1 = 0.445 or 44.5%
As you can see, the markets are predicting by the expiration of February’s futures that the Fed will cut 25 basis points with a very good possibility of a 50 basis point cut. Remember that the next FOMC meeting is in mid-March so unless the market situation changes, there should be no reason the Fed cuts in February. For fun, what are the markets predicting the interest rate would be after the meeting in March?
100 – March Futures = 2.89
- Current Rate 3.5 – March Futures 2.89 = 0.61
- 25 basis point cut: 0.61 *4 = 244%
- 50 basis point cut: 122%
- 75 basis point cut: 61%
- 100 basis point cut: 30.5%
From here until March, the markets are predicting that the current rate of 3.5% will be reduced at the very least by 50 basis points, or to 3%. Remember that the starting interest rate and predictions will change depending on what happens from here until the start of March, but it gives you a decent idea of where the markets think interest rates are heading. In this case, they’re seeing rates slowly drop, especially after the huge emergency cut last week.
There you have it. Math class is over. You’re dismissed! Play it safe today. I have a feeling the markets will be disappointed after a 25 bp cut this afternoon.
Last night, the futures market showed the US markets dropping over 500 points on fears of an emerging recession in the US. While I was hiding in fear at the doctor’s office, Bernanke and the FOMC held an emergency meeting and cut interest rates by 75 bp, bringing both the Fed Funds Rate and the Discount Rate to 3.5% and 4%, respectively. The markets initially opened over 400 points down but quickly recovered within minutes and held steady throughout the day, closing down only 120 points.
