The Mortgage Reports Blog

Using Fed Funds Futures Charts To Explain Mortgage Rate Movement

Never doubt the power of worms words.

Mortgage rates had trended higher throughout May, but when Ben Bernanke used the word "inflation" 55 times in a speech June 4, that trend turned into a spike.  Rates are much higher now and home buyers are feeling the pain.

The chart above is for illustration purposes; it doesn't relate to mortgage rates directly.  But, it does give some insight into market mentality because it's tracking something called Fed Funds Futures.   

How Far Will The Fed Funds Rate And Prime Rate Fall In April?

This graphic charts how think the Federal Open Market Committee will change the Fed Funds Rate at its two-day meeting starting April 29.

Here's how to follow along:

Mortgage Rates Fall On FOMC's Mention Of "Moderate Growth"

This Fed Funds Rate futures chart is pretty astounding and illustrates just how powerful the Fed's words can be.

To help you read the chart, follow these simple guidelines:

• The farther you go to the right, the closer you get to "today"
• The farther you go to the top, the higher the probability of the result
• The blue line represents "5.250% Fed Funds Rate"
• The green line represents "5.500% Fed Funds Rate"
• The purple line represent "5.000% Fed Funds Rate"
• Vertical lines represent milestone events (i.e. FOMC statement)

The chart shows us that markets believe that -- in January 2007 -- there is a 75% chance that the FFR will still be 5.250%.  Last week, that chance was 66%.

Mortgage rates have pulled back in the wake of the Fed's announcement and the chart can also help us understand why.

Look at the green line representing 5.550%.  It actually represents the market's feeling about inflation.  If markets believe that inflation is running too high, then the green line becomes reality. 

Currently, the chance of that happening is just 12% and mortgage rates are lower is response to that expectation.

It shouldn't surprise you that today's mortgage rates are on level with the October 10's rates -- the most recent day that the green line probability was 12%.

What a difference the phrase "moderate growth" makes.

Source
Fed Fund Probabilities:: Current
The Federal Reserve Bank of Cleveland, October 27, 2006
http://www.clevelandfed.org/research/policy/fedfunds/Index.cfm

Visually Understanding Why Mortgage Rates Are Falling

This chart shows the market's predictions of the Fed Funds Rate at the FOMC's December meeting.  It probably looks like gibberish to you, so let me briefly explain what we can all glean from it.

• The x-axis is dates.  This is a running timeline going back 45 days
• The y-axis is percentages.  This represents probability based upon the trading of Fed Fund Futures
• The plotted points represent the possibililties of what the Fed Funds Rate will be after the Fed's December meeting

By looking at the line graphs of 5.00% and 5.25%, we can see why mortgage rates have headed higher this past week after touching on 6-month lows.

At the date of the first yellow line -- labeled "Employment Situation" -- you can see the market's prediction of where the FFR will be in December 2006.  The markets were 85% certain of "no change" to the Fed Funds Rate.  Today, it's about 90%.

However, even as we watch long-term trends, it's the spikes in the chart that give it meaning.  Those spike correspond to "shocks" to the expectations of market players.

Witness:

• September 18, 2006
• September 27, 2006

It only takes one surprise to alter the market's expectation and, therefore, your mortgage rates. 

Source
Fed Fund Probabilities:: Current
The Federal Reserve Bank of Cleveland, October 11, 2006
http://www.clevelandfed.org/research/policy/fedfunds/Index.cfm

Predicting The Outcome Of The FOMC's September 20, 2006 Meeting (T-Minus 22 Days)

20 minutes prior to the release of the Fed Minutes, and markets are predicting with 80% certainty that the Federal Funds Rate will remain unchanged after the September 20 FOMC meeting.

Interpreting the chart above provided by the Federal Reserve Bank of Cleveland, we can see what markets expect:

• 2% probability that the Fed Funds Rate decreases to 5.00%
• 80% probability that the Fed Funds Rate remains unchanged at 5.25%
• 18% probability that the Fed Funds Rate increases to 5.50%
• 0% probability that the Fed Funds Rate increases to 5.75%

The statistics are the result of a formula exacted upon the Fed Futures Markets, in case you care.  If you don't care, that's fine.  It's pretty arcane, but you can read about it if you want to.

I expect the chart to shift in the days leading up to the September 20 FOMC meeting as markets leave their comfort zone about inflation and the Fed's take on it.

Understand How The Futures Markets Work With The Help Of The Philadelphia Eagles

Just like you can buy a stock and take possession of it today, you can also make arrangements to buy a stock tomorrow at a pre-determined price. 

Contracts to buy a fixed amount of something in the future is called a "futures contract" (duh!) and it gives us a glimpse into how traders think a particular event "will go down".

Futures can be a daunting subject, so let's make it simpler by comparing futures contracts to sports gambling.

After last season in the NFL, the Philadelphia Eagles were thought to be a lock to win the 2006 Super Bowl.  Coming off a loss in the 2005 Super Bowl, the birds had managed to keep most of their players and were gelling as a unit.

Shortly after the 2005 Super Bowl loss, Las Vegas oddsmakers put 7-2 odds on the Eagles to win the next year' Super Bowl.  7-2 odds is a 28% likelihood.

And then things went horribly wrong.

First, Terrell Owens lashed out at Donovan McTurtle.  Then, Andy Reid lashed out at T.O.  And once the team reported to training camp, the injury bug hit. 

First Donovan.  Then Owens.  Then Brian Westbrook.  And the losses mounted.

As the Eagles' future grew more bleak with each passing week, the oddmakers actively changed their expectations for the Eagles to win the Super Bowl. 

Last week, the likelihood of the Eagles winning the 2006 Super Bowl had dropped to 3.33%, or 30-1.

Today, there are no odds. 

The Eagles are now mathematically eliminated from the playoffs and so the probability of the Eagles winning the Super Bowl is 0.00%.  The oddsmakers have taken the Eagles off the board for betting.

And in this way, we can better understand Fed Funds Rate Futures. 

Just like betting on the Eagles outcome at the Super Bowl, traders can bet on what the Fed Funds Rate will be after a Federal Open Market Committee meeting.

For today's FOMC meeting, the oddsmakers (i.e. traders) have set the odds of 0.25% Fed Funds Rate hike at 100%.  They've also set a 100% certainty for the January 2006 meeting.

Because of these expectations about the future, the same traders have made other bets, too.  If the playing field changes at all -- like it did for the Eagles -- those bets will change, too.

According to the Fed Funds Rate futures market, there's a 38% probability that the Fed will raise by another 0.250% in March 2006.

(Images courtesy: MSNBC, FrankGalasso.com)