Several Fed officials have recently said that two or three hikes might be appropriate this year. Fed Chair Janet Yellen conferred her imprimatur on the idea of a rate hike on Friday, when she also allowed the possibility of a hike “in the coming months”. In order to get a sense of market odds for one FOMC meeting versus another, it’s instructive to examine Fed Fund calendar spreads.
First, it’s important to understand how Fed Fund contracts are constructed. The final settlement of a given FF contract is the average daily Fed Effective rate over every day of the contract month (whether the month is 30 or 31 days). The daily Fed effective rate can be found here: https://apps.newyorkfed.org/markets/autorates/fed%20funds If the Fed Eff rate is 0.37 on Friday, that rate is used for Saturday and Sunday. The recent Fed Eff rate has been 37 bps. The last day of the month often sees a drop of a few bps in the Fed Eff rate. The expiring FFK6 (May 2016) is 99.6325, or a rate of 0.3675%. So let’s consider the June contract. The FOMC meeting in June is June 15, and there are 30 days in the month. So, if the Fed were to hike 25 bps in June, we would expect FFM6 to go to a price of approximately 99.505 (that is, half the days in June would be at the ‘old’ rate of 37 and half at the ‘new’ rate of 62. So, given that FFM6 settled 9960.5, it represents odds of about 20% for a June hike. (Given that the Brexit referendum is June 23, the Fed may not want to rock the international boat immediately in front of the vote).
The meeting in July is on July 27 of a 31 day month. There is no Fed meeting in August (so August is termed a ‘clean’ month). If the Fed were to hike 25 bps in July, then the July to August spread would go to 21.5 to 22 bps. The spread between these two contracts settled at 9.5 on Tuesday; FFN6 at 99.565 and FFQ6 99.470. This settlement indicates odds of about 44% for a move in July. Clearly, the money markets are more comfortable pricing for a hike in July rather than June.
While I don’t have a particular trade recommendation given the above information, the shifting odds of perceived Fed action may be useful when considering other time sensitive positions. For example, financial stocks may be sensitive to the timing of a move, and various option positions may also be affected.
Alex Manzara
