Based on trading in fed fund futures, market participants expect interest rates to turn negative next year1. This is likely being driven from fears that the Federal Reserve (Fed) is out of ammo to keep financial markets functioning through this crisis.
Fed funds futures are financial contracts that represent the collective opinion of market participants on the path of interest rates over a given time period (the mechanics of futures contracts are beyond the scope of this discussion). These futures contracts are primarily used for two reasons.
The first is for large institutions like banks and bond managers to hedge interest rate risk. For example, if a bank loaned a lot of money at a floating interest rate, they may want to mitigate risk by using one of these contracts (also beyond the scope of this discussion). In effect, these futures contracts act as a tool to control risk levels.
The second is for speculation. Traders use these contracts to make bets on the future direction of interest rates. For example, if a speculator wanted to bet on interest rates rising a year from today, they could buy a contract that positioned themselves to profit if rates did move higher.
Fed fund futures contracts are traded on the Chicago Mercantile Exchange (CME). The CME analyzes activity in this market to calculate the probability of future Fed policy. Meaning, when the media reports that the “market” is expecting interest rates to rise or fall over time, this forecast is derived from speculators’ bets at the CME.
Dotted Lines To Nowhere
The chart below is from a Deutsche Bank presentation in June 2019, and it compares the expected path of interest rates at various times (dotted lines) to the actual path set by the Fed (red line).
For example, notice the two dotted lines in 2009 that go up and to the right in a steep-sloping manner. The first line that year represents where the market expected interest rates to rise through 2010. The second line is a revised view on the path of interest rates halfway through the year.
However, the red line barely moved, implying the market forecast was dead wrong. In fact, given that so many dotted lines deviate from the red line, it’s hard to discern when the market has been right.
The blue-dotted line represents the expected path for interest rates from May 2019. This line indicates multiple rate cuts through 2020 before bottoming just below 1.5%. From there, a slow rise would begin in 2021. While the market’s prediction appeared to be pretty good in the second half of 2019, the rest is suspect. The Fed cut rates in early 2020 as predicted, but they cut them down to zero (way lower than predicted by the market).
The question raised by the Deutsche Bank analyst who put this chart together (below the blue-dotted line) is a valid one. Why would the market be right back in May 2019 if it had been so wrong, so many times in the past?
Let’s ask this same question regarding its current expectation for a negative rate policy in 2021. The Fed is arguably the most powerful financial force on the planet. To say they are running low on firepower is debatable. Key leaders at the Fed have also indicated they do not support this experimental policy - one that has arguably done more harm than good in Europe and Japan. Betting against this takes fortitude.
The Bottom Line
In all the years I worked in equity research and big investment banks, not once did I come across a functioning crystal ball. This was not from a lack of trying either. I looked everywhere. They just don’t exist.
Furthermore, the notion that a collective group of professional fortune tellers has any edge over some random person walking down a street is suspect. Even if they were right more than wrong, how could they prove that it was nothing more than luck?
Nor is this similar to a group of esteemed doctors collaborating to diagnose a rare disease, where training and education improve the odds of prediction. Finance and economics do not mirror the laws of medicine, Newtonian physics, or any other structured process.
There are just some things in this world that are impossible to forecast with any degree of accuracy. Handicapping the future direction of interest rates set by a group of government officials behind closed doors is most likely one of them.
That being said, the fed fund futures market is not inherently flawed. It serves a valuable purpose for those who want to hedge risk and for investors to gauge the pulse of the market. For example, it’s a great tool to see where you stand against consensus. When you disagree, think about how you could be wrong and what you might be missing. Just don’t take it too seriously or think that these speculators are somehow smarter or better than you are at reading tea leaves.
The bottom line is that it’s best to check any expert’s track record before assuming their opinion to be gospel. In the case of interest rates and the fed fund futures market, take these predictions with a big grain of salt.
Mike Sorrentino, CFA
Chief Investment Officer
Brian Malizia, President
Three Key Points
- Some market participants see U.S. interest rates turning negative next year.
- Interest rate predictions have a rather questionable track record.
- Check any expert’s track record before assuming their opinion to be gospel.
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