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Have you ever played the guessing games? Yes , we all have , and the economists always do. But what good is it guessing, when you are basically groping around in the dark trying to figure to where the interest rates might move next? There could be 2 categories of "guesses" or guesswork. One could be the "wild guess" where you just go ahead and put a figure ,like Henry Blodget did when he put an unheard of price target of $400(pre-split) for Amazon.com(NASD: AMZN) and the stock broke through it less than a month later, catapulting him into the league of highly respected analysts in the US. How's that for luck? A phrase was also coined to celebrate this success and it was called "blodgeting a stock." So whenever you put a guesstimate on anything ,be it a stock or the Feds next move it is basically called "blodgeting" in financial parlance.
So if you are proved right , you end up becoming something akin to a pop-icon in your immediate social and professional environs.
The other would be the "educated or the calculated guess". It is here that your probability of making a correct call would at least separate you from the hundreds of desperados at any of the black-jack or casino tables in Las Vegas. How then do we take a calculated guess ?
Take a guess ??
"The Fed Fund futures of course."
Now lets begin with what a fed fund future is know as in the financial lexicon. The Chicago Board of Trade lists future contracts on the Fed Fund rates. The owner of a Fed Fund future is obliged to take delivery of the interest paid on the principal amount of $5 million overnight fed funds held for 30days .The price of a Fed fund futures contract is 100 minus the average Fed Funds rate during the contract month. So what does this exactly mean? Lets say the Fed Funds rate for a particular month averaged at 6%.The settlement rate of the futures contract would be 100 - 6 = 94.
Thus we see that the price of the contract simply implies the expectation for the Fed Funds rate for that particular month .(For option traders only: This is akin to the implied volatility of the option which is extracted from the market price of the option. The Black-Scholes/Garman Kolhagen's model/equation is reversed and one works backwards with all the data available including the market price of the option to calculate the implied volatility).
One might question the accuracy of the Fed Fund contract. Sample this. Out of the past 37 meetings of the FED the futures have called the interest rate move or the lack of it correctly 36 times, and the one which it failed to call was the interest rate move on 18th April, 2001, when the Fed cut by 50 basis points. How's that for a record.
So, now comes the million dollar question, what do we have in store for us on 15th May when the Fed meets again. Lets try to figure out the probabilities for a 50 basis point and a 25 basis point cut. The current Fed Fund rates are at 4.5%.
Scenario-1: The Fed cuts by 50 basis points:
In this case the average rate for the whole month assuming there would be no inter-meeting is :
(4.5% * 15 days) + (4.0% * 16 days) = 4.24%
Therefore the average rate for the Fed Funds for the whole month of May would be 4.24%.
The key point to notice here is that a 50 basis point rate cut by the Fed would produce an average Fed fund rate for the month of just 16 basis points lower than the current rate of 4.5%. Now lets look at where the May Fed funds futures closed yesterday(1st May, 2001). They closed at 95.69, which essentially means that they are pricing in an average rate of 4.31% for the month of May.
Thus we conclude that the May Fed Fund futures contract pricing in an average rate of 4.31% for May is pricing in 19 of the 26 basis points by which the Fed funds would fall in event a 50 basis point cut materializes. Now because 19/26 = 73% , we say that the contract is pricing a 73% chance of a 50 basis point cut in Fed Funds.
Scenario-2 : The Fed cuts by 25 basis points.
Similarly, the average for the month would be at 4.37%. But the contract is already pricing in 4.31%. So we conclude that the market is fully pricing in at least a 25 basis point cut in the rates, and it would be a bad surprise for the markets if the Fed does not deliver.
Therefore the main contention here is whether the Fed does a 25 or a 50 jig. Depending on ones experience and attitude a rational investor could base his investment decisions on this calculated guess of the Fed surely cutting rates by 25 basis points this month or a 73% chance of a 50 basis point cut.
If you want my opinion, I would say the Fed would go 50.
* The author is a Head Trader at Wall Street Global Opportunities Fund
Disclaimer:
The contents of this publication should not be construed as an express or implied promise , guarantee or implication by any of the Wall Street Group of companies that you will profit from the strategies herein or that your losses in connection therewith can or will be limited .
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