Basic, lesson 1 of 4
What the front end prices
Fed funds futures tell you how many cuts or hikes the market expects, and inflation linked bonds tell you what inflation it expects. Read both before you say anything about the Fed.
9 min, 3 checks
1Fed funds futures, read in one line
A fed funds futures contract settles on the average effective fed funds rate over one calendar month. It is quoted as 100 minus that rate, so a price of 95.75 means the market expects the rate to average 4.25% that month.
Implied rate = 100 - futures price
In percent. Compare it with today's effective rate to see how much easing or tightening is priced.
Worked example
How many cuts are priced
- 1Say the effective fed funds rate is 4.35% today (an illustrative figure).
- 2The contract for the month after the next two meetings trades at 96.00, so the implied rate is 100 - 96.00 = 4.00%.
- 3Gap: 4.35% - 4.00% = 35bp of easing.
- 4One cut is 25bp, so 35bp is 1.4 cuts.
The market has one cut fully priced and roughly a 40% chance of a second. That is the sentence a trader says, not 'the market expects cuts'.
Check 1
The effective fed funds rate is 4.35%. A later contract trades at 96.10. How many basis points of cuts are priced by then?
2Breakevens: the inflation the market expects
Treasury Inflation Protected Securities (TIPS) pay a real yield on a principal that rises with CPI. A nominal Treasury pays a fixed yield. The gap between the two at the same maturity is the breakeven: the average inflation rate at which the two bonds earn the same.
Breakeven inflation = Nominal yield - Real (TIPS) yield
| Maturity | Nominal | Real (TIPS) | Breakeven |
|---|---|---|---|
| 5 year | 4.00% | 1.70% | 2.30% |
| 10 year | 4.30% | 1.90% | 2.40% |
| 30 year | 4.60% | 2.20% | 2.40% |
Check 2
The 10 year Treasury yields 4.20% and the 10 year TIPS yields 1.95%. What is the 10 year breakeven, in percent?
Splitting a move in nominal yields into real yield and breakeven tells you why it happened. A 10 year that rises 20bp with breakevens flat is a real rate move, usually about growth or the Fed. The same 20bp with breakevens up 20bp is about inflation.
3How a data surprise travels
Markets move on the gap between a number and what was expected, not on the number. A CPI print of 0.3% for the month does nothing if 0.3% was consensus and can move the 2 year 15bp if consensus was 0.1%.
| Market | Typical move | Why |
|---|---|---|
| Fed funds futures | Fewer cuts priced | The Fed has less room to ease |
| 2 year yield | Up the most | It is the market's bet on the Fed |
| 10 year yield | Up, less than the 2 year | Bear flattener |
| Dollar | Stronger | Higher expected US rates attract money |
| Equities | Lower, growth stocks most | Higher discount rates hit long dated cash flows hardest |
Check 3
Payrolls come in 150,000 above consensus. Which set of moves is the most consistent first reaction?
Terms in this lesson: Federal funds rate, Futures contract, Basis point, Consumer price index.
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