Fed Fund Futures Could Be Setting Market Up for a September Sell-Off

You would think that with everything Fed Chairman Ben Bernanke has said publicly thus far regarding the current turmoil in the mortgage and credit markets, the market might be at least somewhat doubting that a Fed Funds rate cut is coming later this month at the next FOMC meeting. After all, Bernanke came out and said the Fed is not responsible for bailing out lenders and consumers who made bad decisions in a loose lending environment. Quotes like that should at least temper people’s expectations a little bit that a rate cut this month is essentially guaranteed. Well, that does not appear to be the case.

As of late Wednesday, a 25 basis point cut was fully priced into the market and there was a whopping 72% chance of a 50 basis point cut also priced into futures quotes. Given the actions we have seen from the Fed thus far (namely choosing to inject liquidity rather than lower interest rates for consumers) and the words they have chosen in public speeches in recent weeks, I have to take “the under” on the Fed Funds futures bet.

Now, that is not to say that there won’t be a rate cut. That could surely happen, and you could justify it several ways. It just seems to me that the Fed wants to try every other option they have at their disposal before giving in with a rate cut, which many see as bailing out people who made ill-advised decisions and thus contributing to a moral hazard issue.

Because of that, I think saying there is a 100% chance of a cut this month is overly optimistic for interest rate bulls. And a 72% chance of a 50 basis point cut is even more aggressive. Right now, I’d put the odds of a cut of any magnitude between 50% and 75% based on what Bernanke has said and done so far.

I bring this up not because I think people should speculate in the futures markets, but because it’s important to understand what is currently priced into the marketplace. If we don’t get a cut later this month, which I think is certainly more probable than the markets currently are telling us, then stocks are going to sell-off. That is what we open ourselves up to when the market prices in something as a certainty even though there is still an undeniable fact that nothing is certain about the September FOMC meeting.

And even if we do get a cut of 25 basis points, we could still see the market not react positively because more than half of people right now expect 50 basis points (who knows what that number will be at meeting time). Just be aware that the risk-reward trade off right now in the short term doesn’t appear all that favorable as long as you assume two things. One, the fed fund futures market accurately gauges what the market is currently pricing into prices. And two, the market will be reacting to interest rate speculation and action in coming weeks.

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6 Thoughts on “Fed Fund Futures Could Be Setting Market Up for a September Sell-Off

  1. Chad,

    I think that your analysis on this is fair overall- that the stock market is really expecting at least 25bps of cuts at the September meeting and probably a little more- the fed funds market is not a very sound way to estimate the probabilities of a cut at this point.
    The reason is that the fed is currently being overly generous with the financing and liquidity being added to the overnight market. This is causing Fed Funds (which the fend funds futures fix off- the fed fund futures fix at the arethmetic avereage of the daily fed funds rate)to fix much lower than the traget rate. So much so in fact that August fed funds settled at an implied 5.022 rate. That would seem to indicate that th e fed cut rates in August. This is not the case as we know but that it added significant amount of liquidity to the system. The september fed funds you mention have a similar scaling factor in them.

    Like i said the conclusion is fine but the causation may be a bit shakey

  2. I have read/herad other investment professionals state that the market is “pricing in” a rate cut. How do you determine that? What in the futures market leads you to that conlusion?

  3. Chad Brand on September 6, 2007 at 1:53 PM said:

    AG: I agree that Fed Fund futures are not very good predictors of Fed action. This has been proven time and time again. I do think it tells you what is priced into the market, but oftentimes people assume these are the same thing. I don’t think the market is a good predictor, it’s just a voting mechanism for traders in the short term.

    JJ: A futures contract will have an expiration date and a quote associated with it. So, let’s say September Fed Funds are trading at 5.00%. That implies that the market expects Fed Funds rates to be at that level at the expiration date. You simply compare the current Fed Funds rate (5.25%) to the futures quotes to see what the market is pricing in.

  4. Anonymous on September 6, 2007 at 8:21 PM said:

    Chad, Excellent blog by the way!

    The way I see it is that Aug 17 is when they cut the discount rate and they extended the lending term to 30 days which falls to about Sep 17. Sep 18 is FED meeting where they will probably assess if this discount window is working and whether the injection of liquidity is working.

    If it is, why cut rates. Also, the FED the treasury together with Fannie Mae are engineering some something (I don’t want to call it a bailout) in the background that will indirectly inject liquidity into the market.

    If they don’t cut, market will sell off and will probably test the lows set in August

    What you think, Chad? I’m not even considering FED Funds futures because as you said it’s overly optimistic

    John

  5. Anonymous on September 6, 2007 at 10:42 PM said:

    When I sat back and thought about it all, I was thinking that the market would spike later this month regaining the years losses. I’ll explain how I see it.

    I took a look at the CIA’s website and found the United States fiscal year starts and ends 1 October – 30 September.

    So, it’s almost given that the Feds are going to cut at a minimum of half a point! There seems to have historically always been a bailout. Plus, economy seems to be slowing, even Walmart reduced it’s earnings. So, continual liquity injections are not going to cut it, rates need to mist downward. We are experiences aftershocks from the 1% fed fund rates not too long ago and the super lax issuance of credit.

    The magician always has a trick up his sleeve. Let’s wait and watch the magic trick!

    Manoj Patel

    PS: Alan Greenspan’s book comes out on the 17th of this month. I’m going to try and preorder a copy and suggest that you do also.

  6. Chad Brand on September 7, 2007 at 6:59 AM said:

    Hi John:
    Glad you like the blog.

    I agree that the Fed might not need to cut rates like everyone thinks, mainly because a rate cut really doesn’t solve the real issue here.

    The lack of credit market liquidity has to do with investors no longer willing to take on risk at the prices we have been used to. Lowering Fed Funds won’t change this.

    It might help to bail out some home buyers, but defaults and foreclosures are less of an issue than the credit market freezing up, even though the former are on the rise and I’m not saying that is a non-issue. I’d just be way more concerned about good firms not having access to liquidity for a long period of time. It will pass at some point, but the short term could get ugly if we see this for several more months.

    Today’s jobs report gives the Fed more ammunition to cut, although monthly variations can be all over the place, so I would not read too much into it yet. It seems like the Fed has a history of giving in with rate cuts, and it may do the same this time around, but I think such action would have more psychological purpose than economic purpose given the current issues in the marketplace.

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