Contract boils down Fed action to ‘yea’ or ‘nay’

HUNTINGTON BEACH, Calif. — For asset managers, forecasting whether the Federal Reserve will cut U.S. interest rates for the first time in four years might become a little easier, thanks to a budding derivatives contract.
The Chicago Board of Trade’s binary options on the federal-funds target are simple “yes/no” contracts that allow investors to bet on what the Federal Open Market Committee, the U.S. central bank’s policy-setting arm, will do with the overnight interbank lending rate: leave it unchanged or move it up or down.
Launched last summer, the binary options are gaining volume amid rising uncertainty about the Fed’s policy outlook. Open interest, a gauge of futures-trading activity, crossed the 20,000 contract mark in February as investors pondered whether a marked slowdown — and not inflation — is the main risk to the U.S. economy.
The new options are the latest in a list of well-established rate prediction contracts, such as the CBOT’s fed funds futures, options on those futures, and the Chicago Mercantile Exchange’s Eurodollars, which are tied to the three-month London interbank offered rate.
“For a very short horizon, like a few days, futures do a good job,” said William Melick, associate professor of economics at Kenyon College in Gambier, Ohio, and a research associate at the Federal Reserve Bank of Cleveland. “But for an FOMC meeting coming in three or six months, a fund manager would be better to use binary options, even regular options, rather than futures for that horizon. The reason is that as the FOMC meeting gets closer, market opinions consolidate around two outcomes: no change, or a [quarter]-point increase or decrease.”
Mr. Melick, previously a senior economist at the Federal Reserve Board in Washington, was interviewed at an annual risk management conference where he presented a paper, “FOMC Probabilities from the Fed Funds Complex.” The conference, sponsored by the Chicago derivatives exchanges, was held here March 4-7.
Rate expectations
Mixed economic reports and former Fed Chairman Alan Greenspan’s mention of a possible recession last month fueled expectations that the Fed might lower the rate — now 5.25% — this year. On March 9, following news of a healthy job market in February, the odds of a June interest rate cut, as embedded in the futures, were slashed to 32%, from 66%. Such wide fluctuations are often found when a monetary policy cycle nears its end.
“Our expectations are that interest rates will be lower by [half a percentage point] by yearend,” said Edward Hoyt, head portfolio manager at the $157.9 billion California State Teachers’ Retirement System in Sacramento, who follows swings in market sentiment reflected by various rate futures and options for informative purpose. “Every day, those instruments give an indication of what the market generally thinks in terms of Fed policy.”
While Mr. Hoyt agrees that the first rate cut since June 2003 would be an inflection point, he also said: “At CalSTRS, we have a long-term investment horizon. We have an asset allocation committee that meets every month or when needed. We want to know what to expect in the long run. With that said, short-term developments are not weighed that heavily.”
For Milton Ezrati, senior economic and market strategist at Lord Abbett & Co. LLC, a Jersey City, N.J., firm with $104 billion in assets under management, binary options fit well the Fed’s current decision-making process.
Starting in 1994, U.S. central bankers elected to set the funds rate target at the eight FOMC meetings a year and immediately announce their decision. The change in the policy process ended the long-standing practice of signaling the funds rate target via open-market operations, with the New York Fed trading desk buying and selling securities to banks to indicate the new target.
Useful and clear
“Certainly, binary options are a very useful instrument, and a very clear one, too,” Mr. Ezrati said in an interview. “Their popularity will rise and fall with the amount of uncertainty about future Fed action. That contract will become popular and remain popular as long as there is uncertainty,” Mr. Ezrati said, adding that he expects Fed policy to remain on hold for the foreseeable future.
“We have used the old futures to get a feeling of what the market feels. Binary options would give us a good idea of what people think. Knowing how you differ from the consensus is critical when you are investing,” he said.
When it comes to looking at contracts that monitor expectations, volume is an important feature. Nowhere is it deeper than in Eurodollars, the world’s most liquid financial derivatives, when it comes to anticipating U.S. rates beyond a six-month horizon.
“Fed funds futures and options are very widely used predictors of what the market expects fed policy will be, but past six months, the liquidity starts to taper off. You can make similar predictions of Fed policy using Eurodollars futures as liquidity goes much further out the curve, up to 10 years,” said Peter Barker, director of interest rate products at the CME, who noted that Eurodollar volume averages about 1.3 million contracts a day in the first year, 860,000 in the second and 103,000 in the third. “So there are very few problems with liquidity for the first three years,” Mr. Barker added.
According to Mr. Melick, the Fed itself follows the various rate derivatives instruments that attempt to predict future fed fund rates to gauge and sometimes influence market expectations.
“It allows for the possibility of two-way communications between the market and policy makers. FOMC members clearly are also using the fed funds complex to understand market expectations, and markets do exert some pressure on the Fed to explain itself,” Mr. Melick said, noting the trinity of influences among market signals, Fed statements and economic indicators as harbingers of future rates.
“If FOMC members see market expectations moving in a way they find surprising, they’ll try to manage those expectations by being as clear as they can about their intentions; it’s like listening to their own echo,” he added.