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Perhaps the most-watched U.S. financial benchmark -- the Federal Funds target rate -- is attracting significant new attention from traders as volatility returns to the U.S. interest rate market, after a prolonged period of stable and very low rates.

Federal Funds (FF) futures settle each month to a simple average of the daily Effective Federal Funds Rate subtracted from 100. The futures contract allows firms the ability to hedge short-term interest rates or to express a view on the Fed's likely direction of travel.

FF contracts with longer terms to expiry also allow market participants to act on views as far ahead as a year where there is greater uncertainty, given that the Federal Reserve incorporates new economic data into each meeting's outcome.

Managing Rate Risk

After a long period of interest rate stability in the wake of the global financial crisis, with a target range of 0-0.25%, the Fed announced a series of nine increases between 2015 and 2019 followed by a cuts in autumn 2019.

This period of greater central bank activity led to a significant renewal of interest in trading and hedging Federal Funds futures.

Volume and open interest trended sharply upward, with visible spikes preceding rate changes. Even when compared to the most active periods of the low-interest era, both volume and open interest increased by around a factor of five. For 2019, average daily volume has reached nearly 400,000 contracts, with open interest around 2.2 million. Using the contract multiplier of $4167, these numbers represent around $1.6 billion and $9 billion in notional exposure, respectively.

Participation Triples

This growing volume was not simply concentrated among a few extremely large players, but rather came from new participants and smaller players increasing their holdings over time.

The Large Open Interest Holders count tracked by the CFTC shows that the number of counterparties holding reportable futures positions has more than doubled since the recession. Compared to the depths of the zero-interest rate environment around 2013, they have more than tripled.

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Predictive Power

Some market participants also use the price signals from Federal Funds futures as a predictive signal of the FOMC's likely rate decisions. Comparing front-month Fed Funds futures prices, as observed four weeks ahead of a Fed meeting, with the Fed target rate after the meeting shows that the futures market is a relatively accurate guide.

Over the last 15 meetings to September 2019, Fed Funds futures have priced an average around two basis points away from the target rate, with a maximum divergence of 11 bps when moves of 50-75 bps occurred regularly. The two outliers arose in January and October 2008, when the Federal Reserve made emergency cuts totaling 125 and 100 basis points for those months.

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Futures prices a month out did not anticipate off-cycle or larger than standard cuts, but after each unscheduled cut the futures quickly re-priced to include the new expectations, landing within 10 bps of the realized target rate.

The growth in trading volume and participation in Fed Funds futures looks to have increased the spectrum of viewpoints being incorporated into its price discovery, increasing its predictive abilities. But whatever the cause, the Fed Funds futures serve as an efficient tool for near-term interest rate hedging.

In a time of shifting expectations about where the Fed will or won't move its target rate, that makes it a key barometer for anyone following financial markets.

-- Written By Owain Johnson and Bobby Timberlake

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