Fed Reserve lift-off will reinvigorate key market gauges

The US central bank is getting used to the idea of lifting rates above zero for the first time in seven years. That will reinvigorate some old-school market gauges. People used to watch Fed funds futures, Eurodollar derivatives and a clutch of traded measures of inflation like hawks (or doves). These indicators are due fresh attention – even if their meaning has morphed.

The Fed guessing game will intensify as traders make bets on what Chairwoman Janet Yellen and her colleagues will do at each of 2016’s eight monetary policy meetings. Fed funds futures, nowadays helpfully analysed on the CME’s FedWatch Web pages, provide a market-implied trajectory for overnight interest rates in the near term.

There are wrinkles in the post-financial crisis world, though. For instance, if the Fed sticks to a range for the Fed funds rate rather than a specific level – the official target for seven years has been between zero and 0.25 per cent – it makes the meaning of futures prices fuzzier because calculating implied probabilities of Fed moves requires assumptions about exact target rates.

More broadly, financial markets have changed since before the financial crisis. Banks must hold more capital and they face other regulatory constraints, while central bank balance sheets have expanded dramatically – the Fed’s has swollen to $4.5 trillion (Bt162 trillion) from under $1 trillion in early 2008.

 

New distortions

Such effects could create new distortions relating to inventory levels, market liquidity and trading norms. That’s even more significant for other tools like overnight indexed swap (OIS) rates and Eurodollar futures. Using Eurodollar futures, for instance, to glean the market’s view of the longer-term path of Fed policy involves estimating the so-called basis, or gap, between Libor and Fed funds rates. Pre-crisis rules of thumb may prove way off.

Fed watchers will also eventually need to track inflation again. Statistical estimates, even those aiming to exclude energy costs, could be suppressed by recent low oil and commodity prices. Financial measures, like break-even rates on US Treasury inflation-protected securities or TIPS, may suffer from the same post-crisis market distortions.

Traditional navigational instruments may still point in the right directions, but traders feeling out how they now relate to each other could cause a few market fender benders in the years to come.