The Fed funds Rate
The Fed funds rate is the rate at which banks lend their excess reserves at the Fed to other banks in need of increasing their reserves. As such it directly affects the ability and willingness of U.S. banks to make loans. It is also a key interest rate that has a rippling effect on many other interest rates. The Federal Reserve has traditionally made managing the Fed funds rate its primary tool of monetary policy.
Prior to December 16, 2008, the Federal Open Market Committee voted on a target Fed funds rate, but on that date, the Fed changed to a policy of announcing a target range of zero to .25%. That range was left unchanged until December 17, 2015, when it was raised to .25% to .50%. Each change after that has been an increase or decrease in the range in increments of .25%.
Databases often use the top end of these target ranges as the target rate. In addition, there is also an “effective Fed funds rate” which is a volume-weighted median of overnight federal funds transactions updated daily by the New York Federal Reserve. The CME Group offers monthly Fed funds futures contracts based upon the 30-day average of the effective Fed funds rate at settlement. Futures prices reflect the opinions of market participants with respect to future effective Fed funds rates.
Post-Recession Monetary Policy
U.S. monetary policy changed after the Great Recession of 2008, perhaps forever. The Fed funds rate was pushed down to an historic low of 0% to .25% and kept near zero until the end of 2015. Never before had the Fed gone to such extremes to stimulate the U.S. economy, and never for so long, and rarely with so little apparent effect on economic growth. It did boost the stock and bond markets, however.
Arguably, the Fed funds rate has been one of the primary drivers of the stock market in recent years. When trying to ascertain what the Fed is likely to do in the months ahead, the Fed funds futures market provides a very handy gauge of consensus market opinion, and as such it can be a handy asset allocation indicator for stocks.
Fed Funds Futures Implied Six-Month Forward Rate
Fed funds futures contracts are traded with monthly maturities out as much as 36 months into the future. However, liquidity for Fed funds futures contracts (as measured by open interest) tends to be highest for nearby contracts. My objective is to measure expectations with respect to future effective Fed funds rates, with a relatively constant horizon length that will be long enough to encompass at least a couple of Federal Open Market Committee meetings. Open interest is still fairly good out six months, so I selected that horizon.
As shown in the graph above, the 6-month forward implied rate is sometimes a bit above the current (spot) effective Fed funds rate, and sometimes it is a bit below. Importantly, changes in direction are usually reflected in the futures market before they happen in the spot market. This is why using futures is much more effective as an input to a market forecast. The stock market is driven by expectations, and particularly, changes in expectations.
The graph above shows the expected change from the current effective Fed funds rate over the next six months implied by the 6-month forward futures market price. My presumption is that an expectation of future monetary easing, reflected by an expected decline in the Fed funds rate, is positive for stock market returns, and vice-versa. That is, when the orange line is above zero (as it was for several years before the end of 2018), that has a dampening effect on stock market returns.
On the other hand, when the orange line is below zero, as it was during all of 2019 for example, this can boost the stock market. The three cuts in 2019 were signaled ahead of time by the futures market, and stocks reacted very positively, sending the S&P 500 up 31.5% for the year.
The graph above shows the rolling 60-month correlation between the month-end 6-month forward implied Fed funds effective rate change and the next month’s return of the S&P 500. The correlation has been mostly positive, particularly in the post-Great Recession era. At present the trailing 60-month correlation is a very strong 18%, indicating that the stock market continues to be driven by concern about Fed policy.
If the futures market turns out to be correct and the Fed does cut rates, that is likely to be very well received by the stock market.