Fed Funds Futures—Understanding Expectations
10/31/2008 1:07 pm EST
Traders can buy and sell futures based on the Fed funds rate and expectations for changes in that rate. If you think the Fed will raise rates in the future, you would sell these futures, and if you think the Fed will lower rates, you would buy these futures contracts. These are a great way for institutional traders to hedge interest rate risk and speculate on changes in the future.
The Fed funds futures can be useful for forex traders to understand what market expectations are for the long-term trend. If the Fed funds futures rate shows a rate that is lower than the current rate, traders are expecting a cut, which would typically be bad for the USD. If traders are forecasting a rate hike in the future, which would be shown in a decline in the Fed funds futures chart, it would normally be good for the USD.
It is important to remember that the Fed funds futures chart is showing what traders think will happen to the rate in the near future, not what it is right now. On the Learning Markets Web site, under the forex tab, and in each pair's analysis page, you can see the current chart for the Fed funds futures rate. Here is a snapshot of what that looks like as I write this article in October 2008.
The Fed funds futures chart is annotated, so it is easier to understand what traders are forecasting. The horizontal lines show what price the futures chart would have to be at if traders are forecasting a cut or hike, and how much that cut or hike is expected to be. If current prices are equal to one of those horizontal lines, you can draw a conclusion about where traders think rates are going and can use that information in your forex trading.