Despite what you may have read elsewhere, the probability of a fed funds rate cut has increased significantly over the last few weeks.
Since the stock market began to sink a week ago, the federal funds rate for next January, as implied by futures markets, has plummeted to 5% from 5.2%. As a result, the implied odds of a quarter-point rate cut from the current 5.25% are said to have risen from 20% to 100%.
Well, nobody in their right mind would ever describe the odds as 100%, but let us not get diverted.
Lou Crandall, chief economist at Wrightson Associates, says while such action is commonly attributed to increased expectations of a Federal Reserve rate cut, that would be a mistake. The real reason, he said, is that investors are fleeing risk and seeking safety in Treasury bonds and bills and other high-quality paper, sending their prices up and yields down. As a result, the entire yield curve has shifted down. To maintain parity with that lower yield curve, the implied federal funds rate also has to drop, he says.
Mr. Crandall says, “99% of the universe, including a lot of people in those trades, don’t do it because they think the Fed will ease but because that’s the way the yield curve is shaped.”
But wait a minute: isn’t that a violation of efficient markets? If fed funds futures were out of line with a realistic expectation of Fed action, couldn’t smart people take positions in the mispriced futures and make a bundle six months later when it turns out the Fed didn’t cut rates? And shouldn’t such arbitrage push expectations of the Fed and pricing of futures back into line?
No, says Mr. Crandall, for two reasons. First, the Fed has gotten more predictable but gives no guarantees on where rates will go, so there is no assured profit on such a trade (so it wouldn’t really be arbitrage). Second, “The amount of money backing people who have opinions about where the Fed will be in six or nine months is dwarfed by the amount of real money being invested in short-term credit markets.” Nervous investors are willing to accept a lower yield than what might ordinarily be justified based on the economics in exchange “for safety. Market participants know that perfectly well. That’s why it’s called a flight to quality.”
The first odd thing about this statement is that it seems to suggest that there are two competing theories of how fed funds contracts get priced. The first theory evidently claims that the contracts reflect investors’ expectations of Fed actions, and a second, supposedly contradictory theory claims that the contracts just follow the Treasury yield curve, as if we have to choose whether the fed funds futures contracts are priced in a way that is consistent with expectations of what the Fed is going to do or if instead they are priced in a way that is consistent with the yield curve.
But of course the answer is that they are priced in a way that is consistent with both. These and every other financial market are responding to exactly the same news that we’ve been discussing here, and drawing the same conclusions as we have. The latest economic news points to a considerably higher likelihood of economic softness, a situation in which the Fed will want to lower the funds rate and short-term interest rates will come down. That scenario is priced in the fed funds futures, in the term structure of Treasuries, in the stock market, in foreign exchange, and what not. Here’s what’s been happening over the last few weeks to the price of the November fed funds futures contract, the simple-minded interpretation of which (and the one that I favor) is that the expected fed funds rate for November has now fallen to 5%.
A second idea in the statement quoted above is the suggestion that one needs to add a significant risk premium to that fed funds futures calculation in order to arrive at the objective expectation of what the fed funds rate will be. It is true that risk premia play a role
in the Treasury term structure, and fed funds futures should incorporate that same risk premia. A recent paper by Monika Piazzesi and Eric Swanson
finds some indication that risk premia may play a role in longer-horizon fed funds contracts. But evidence for significant risk premia operating in very short-horizon fed funds contracts is much harder to find,
as indeed theory predicts it would be. In recent years the Fed’s actions have become much easier to predict. As the accuracy of your forecast improves and the time horizon for your forecast gets smaller, the risk premium necessarily shrinks, and the risk premium on something you know with certainty has to be exactly zero. Perhaps Crandall is right that risk premia could be playing some role in the January fed funds futures contracts. But I find this story much less plausible for October or November contracts, and, as the figure demonstrates, movement in these was quite dramatic this week.
My guess is that we will indeed see a cut in the fed funds rate by the October 30/31 meeting, if not sooner.