Fed funds futures are financial market contracts that can be used by investors to observe the market's guess about the probability of an interest rate change by the Federal Reserve. This information is often reported by the media, and investors can use this information to make investment decisions.
But what exactly are the Fed funds futures and how can an investor use these financial contracts to make investment decisions? In this article, we provide the facts of Fed funds futures and how to interpret them.
Fed Funds Futures and What You Can Learn From Them
To gain a better understanding of Fed funds futures and how to make investment decisions based upon them, let's break down the meaning of Fed funds and how futures work:
Also referred to as Federal funds, Fed funds are excess reserves that commercial banks keep on deposit at one of the 12 regional Federal Reserve banks. These deposits are typically used by the Fed to make overnight loans to market participants to meet their lending and reserve needs. These loans are typically unsecured and charge low-interest rates, called the Federal Funds Rate.
A futures contract is not the same as a conventional securities investment. It's actually an agreement between a buyer and seller of the contract that an underlying asset – such as a commodity, currency or index – will be bought or sold for a specific price, on a specific day, in the future (expiration date). The buyer or seller is predicting the direction of the price (higher or lower).
Since the nature of the futures market reveals what investors expect the price of an underlying asset or index will do in the near future, it can be used as a tool to make other investment decisions. For example, in the case of Fed funds futures, an investor can make a guess about the direction of interest rates that are associated with the Federal Funds Rate. This knowledge can then help the investor decide what investments they may want to buy or sell.
Example of Using Fed Funds Futures for Investing
Interest rates can have an impact on the price of other investments, such as certain stocks, bonds, or mutual funds. Bonds and bond mutual funds can be especially sensitive to changes in interest rates in the short term. For example, bond prices tend to fall when interest rates are rising. If an investor expected that interest rates could rise in the near future, they may want to reduce their exposure to bond funds, which could in turn decline in value.
Caution About Fed Funds Futures and Investment Strategies
An investor could follow the Fed funds futures to make an educated guess about the future direction of interest rates and make adjustments to their portfolio accordingly. However, it's important to keep in mind that other investors are also looking at the same information. The financial news media also reports the information so that it is widely known.
Since the Fed funds futures are publicly reported, the price for interest-rate sensitive investments will quickly be reflected in that information. For example, if the Fed funds futures reveal that investors expect interest rates to rise in the near future, the prices for bonds and bond funds may fall at the open of trading on that same day. If you're not able to stay ahead of the market, you won't be able to take advantage of price changes.
It's also important to note that Fed funds futures reflect the opinions of investors trading in the futures markets. This means that the futures may or may not reflect what will actually occur. If Fed funds futures predict a rise in interest rates, this is not a guarantee that the Fed will actually increase the Fed funds rate.
In summary, Fed funds futures are used by traders for making short-term investment decisions. This type of investment approach is speculative and it is not appropriate for most long-term investors.