Here in the United States, we’re heading toward a long weekend to celebrate the Independence Day holiday. One question I’m occasionally asked is when the U. S. bond markets are closed for holidays. While many holidays are also days off for banks and credit unions, there are exceptions. On top of that, in most cases, the bond markets will have an early close before the holiday.
If you’re trying to place a trade near a holiday, it’s good to know what the market schedule is. With that in mind, I wanted to share a couple of resources with you.
Derivatives firm Chatham Financial offers another good resource. They have an online interactive calendar that shows the dates when the market is closed in New York and London. You can also import the information directly to your calendar if you’d like. The other thing I like is that the calendar looks out ten years, so if you need info about a future date for a securities or derivative, it’s available.
Both the SIFMA and Chatham Financial holiday calendars are great resources if you need to know the holiday schedule for the U. S. bond markets.
If you’re working in banking and finance, you’ll no doubt find yourself talking about the Federal Reserve, the FOMC, and the interest rate environment. For finance geeks like us, keeping up on the latest from the Fed is on par with following your favorite sports team or professional athlete. We just can’t help ourselves!
As you follow the market’s interest rate expectations and try to understand what actions the FOMC is likely to take, you’ll encounter a lot of financial media discussion about the Fed funds futures market. Understanding Fed funds futures and how to analyze the information about them can help us better understand market expectations for what it believes the Fed is likely to do. Let’s explore Fed funds futures and how to analyze them.
What Are Fed Funds Futures?
We’ll begin by defining what Fed funds futures are. Fed funds futures are contracts based on the Fed funds rate, which is the overnight rate at which banks lend money to each other and the primary benchmark rate the Federal Open Market Committee (FOMC) uses to implement monetary policy.
The futures contracts are traded on the Chicago Mercantile Exchange (CME) and are available for various maturities, ranging from overnight to one year. Investors use these contracts to hedge against changes in interest rates or speculate on the future direction of overnight rates.
How Fed Funds Futures Pricing Indicates the Expected Interest Rate
Fed funds futures contracts trade at a discount to their face or par value. The difference between the price and par represents the average effective Fed funds rate until the contract expires at the end of each month.
For example, as I’m writing this, the June Fed funds futures contract is priced at 98.9175. If we subtract that amount from par, or 100, we can estimate that the average effective Fed funds rate between now and contract expiration on June 30 is about 1.08%.
Calculating a Future Rate for Fed Funds
Now let’s take things a step further. The current effective Fed funds rate is 0.83%, and the average for June is 1.08%. That means the market expects the Fed funds rate to rise before the end of the month.
With the next FOMC meeting scheduled for June 15 and doing a little weighted average math, we can use the current rate and the average to solve for the effective Fed funds rate during the second part of the month. It comes in at 1.33%, which is half a percentage point, or 50 basis points, higher than the current rate of 0.83%. As a result, we can determine that the market is anticipating that the FOMC will raise the Fed funds rate by 50 basis points at the June meeting.
Fed Funds Futures Tools
Okay, so you’re probably sitting there thinking, “Chris, I can see how that can be helpful. But who has time for all that math and calculating!” And you know what – you’d be right.
But here’s the good news – you don’t have to do all that work. I’m going to share with you a couple of resources based on Fed funds futures data that you can use to determine what the market expects the Fed to do with short-term interest rates.
Resource #1: Bloomberg’s “WIRP” Screen
The first resource is from Bloomberg. It’s called the WIRP screen, which stands for “World Interest Rate Probabilities.” You can pull up the WIRP screen on the Bloomberg terminal or ask your broker for a screenshot.
The WIRP screen takes the information for all Fed funds futures contracts being traded and calculates probabilities for moves by the FOMC at their next meeting as well as future ones. The table of information that Bloomberg provides includes the number of hikes or cuts at each meeting, with each move equal to 25 basis points, the percentage probability of a move, and the implied overnight rate and change.
One thing I like about the Bloomberg WIRP screen is that you can pull up historical information for the past year. So if you wanted to compare the Fed funds futures outlook today with a month ago, for example, you could get that information easily.
Resource #2: Chicago Mercantile Exchange’s “FedWatch” Tool
Another available resource comes from the CME itself. The CME’s FedWatch Tool also provides probabilities and information based on the Fed funds futures market data.
One thing I want to point out is that the methodologies used to calculate the probabilities are slightly different between Bloomberg and CME. Without doing a deep dive, CME uses something called conditional probability, which can sometimes create a little confusion in terms of probable rate moves by the Fed.
Personally, I prefer to use the Bloomberg WIRP screen because the information feels a little more intuitive to me. And as I mentioned earlier, even if you don’t have access to a Bloomberg terminal, your broker can grab a screenshot of the information and have it in your inbox pretty quickly.
Can Fed Funds Futures Predict Future Rates?
As I mentioned earlier, these resources allow you to look at current and future Fed meetings. While being able to see what the market expectations for FOMC meetings in six or nine months might be nice, I want to caution you against treating that information as highly accurate.
When analyzing Fed funds futures, my rule of thumb is to pay attention to the next couple of upcoming meetings and stop there. That’s because the accuracy of the data gets what I’ll call a little “squishy” as you move further and further into the future. It’s like trying to make personal plans using a long-range weather forecast. It might be correct, but the possibility of it being less accurate increases as you move further into the future.
It’s also important to remember that what the Fed funds futures market shows us are just expectations. When the time comes, the actual Fed decision could turn out to be different from what the market expects. The futures contracts will shift as market sentiment does, so always keep in mind that Fed funds futures aren’t a crystal ball. They’re indicative of what may happen but not necessarily predictive of what the FOMC will do.
Fed funds futures can be a helpful tool for analyzing the market’s expectations for Fed policy. Using the information available on the futures contracts can help us understand what could happen with short-term interest rates. But Fed funds futures are just one tool in the financial market toolbox, and a Fed watcher should use them alongside other information sources to get a well-rounded view of what might happen at the next Fed meeting.
I recently spoke with a community banker about yield curves and their slopes. While he understood that yield curves could steepen or flatten, he’d heard someone referring to changes in the yield curve as “bull flatteners,” “bear steepeners,” or something similar. I helped him understand the difference and wanted to share the same information with you.
Previously, I explored yield curves and yield curve slopes. As a quick refresher, a normally sloped yield curve has rates that gradually increase as you go further in time. Sometimes, the difference between short- and long-term rates can be very high, which we refer to as a steep yield curve. When there’s minimal difference between the short- and long-end of the yield curve, that’s called a flat yield curve.
As interest rates on a given yield curve change over time, the yield curve’s slope can also change. If the spread between short and long interest rates increases, we say the yield curve is steepening. On the other hand, if the difference between short and long rates decreases, we say the yield curve is flattening.
Introducing Bulls and Bears to the Mix
But what’s all this talk about bulls and bears, and how does it affect a yield curve’s slope? Let’s look at an example.
Suppose we have a typical yield curve. It has a positive slope, with rates gradually increasing as we move further out on the curve.
Now, let’s assume that the yield curve is going to steepen. But wait a minute! While we know it’s steepening, we don’t know if that’s because short-term interest rates are dropping or if long-term interest rates are going up. No matter what happens, the yield curve will get steeper, right?
This is where the bull and bear terminology comes in. The terms are associated with the stock markets. We consider something bullish if it means that prices are rising, while a bearish situation involves prices falling.
We can use the same terminology in the bond markets. A bullish move means that bond prices are on the rise, while a bearish one means that bond prices are receding.
If we go back to bond basics, we know that interest rates and bond prices move in the opposite direction when things change. If interest rates rise, bond prices go down. And when interest rates fall, then bond prices go up.
Bull and Bear Steepeners
For example, if the reason a yield curve steepens is that short-term rates are dropping, that means that the price for shorter bonds is going up. Since that’s bullish by definition, we refer to this as a bull steepener. A bull steepener happens when short rates drop.
On the other hand, if the steeper slope is due to an increase in long-term rates, that would indicate that long-term bond prices are falling, which is considered bearish. So a yield curve that steepens because long-term rates are rising is called a bear steepener.
Bull and Bear Flatteners
We take a similar approach when the yield curve is flattening. If the yield curve is getting flatter because long-term rates are coming down, that means the underlying bond prices are going up, which is bullish. So when the yield curve flattens due to a decrease in long-term rates, that’s called a bull flattener.
And if the yield curve is flattening because short-term rates are rising, then we’re looking at decreasing short bond prices, which is bearish. So a bear flattener happens when short-term rates are on the increase.
So to recap:
I hope this is helpful. If you have any questions about it, please reach out!
As we continue toward the eventual retirement of LIBOR as a benchmark, I’ve been having more conversations with clients and other community bankers about the LIBOR transition. The amount of effort needed to prepare for the LIBOR benchmark going away varies, depending on how much of a role the index plays in operations.
The Office of the Comptroller of the Currency (OCC) recently released an updated LIBOR self-assessment tool to help banks evaluate how prepared they are for LIBOR’s retirement. It’s in the form of a checklist, allowing you to gauge your progress quickly.
The checklist tool covers four primary areas of consideration:
Exposure Assessment & Planning – This section helps you develop and evaluate the LIBOR transition plan for your community financial institution, along with factors to consider.
Replacement Rates – What replacement rate has your bank decided to use? While none of the regulators have endorsed a specific replacement benchmark, they expect institutions to identify what they’ll be using in LIBOR’s place. Some examples I’ve discussed with clients have included SOFR, Prime, Ameribor, and BSBY.
Fallback Language – Reviewing new and existing contracts and notes is a critical part of the LIBOR transition process. It also has the potential to require more work, especially if you have to review and modify a more significant number of documents.
Progress & Oversight – How is your bank doing in its progress toward transitioning away from LIBOR? The amount of effort will be based on the size and complexity of your bank’s LIBOR exposure.
For investors in fixed-income securities, yield and interest rates are critical drivers when making investment decisions. If you follow the bond markets, you’ll no doubt hear mention of the yield curve and its slope. But what are they, and can they provide insight into future interest rates and the overall economy? Let’s explore what the yield curve is and how to interpret the shape of the curve.
The yield curve graphically depicts the yields on different maturities of debt instruments. It is simply a line plot of interest rates by maturity, providing investors with a visualization of yields and interest rates. If you take all the yields for a given type of interest rate (for example, Treasury rates) and plot them on a line, congratulations! You’ve got a yield curve.
A yield curve plots the yields of different maturity bonds against their corresponding time to maturity, allowing investors to visualize the term premium (or discount) for each maturity. Typically, long-term yields are higher than short-term ones since investors want to be compensated for tying their money up for more extended periods, known as “maturity risk.” Investors also consider potential inflation and any loss of purchasing power over time.
You can plot a yield curve for any fixed-income bond type. For example, you can find curves for Treasury and other government bonds worldwide, municipal bonds, agency bonds, and corporate bonds. If you have access to Bloomberg (either directly or with the help of a broker), you’ll find dozens of curves available.
What Is the Yield Curve Slope?
When we’re talking about yield curves, there’s one term with which you need to be familiar. That is the term “slope.” The slope is the difference between short-term and long-term interest rates on the curve. A common slope measure is the difference between two-year and ten-year Treasury yields, otherwise known as the “2s/10s spread.”
Usually, a yield curve will have higher rates as you move further out the maturity scale. This goes back to the idea of maturity risk that we discussed earlier. We refer to this as a positively sloped yield curve, with longer rates higher than shorter ones.
There are three basic yield curve shapes that you’ll want to know. Each of them depends on the degree of slope in the curve.
Steep Yield Curve
A steep curve happens when you have a yield curve with very high long-term rates compared to short-term rates. As you look at the curve, it looks like a very steep hill that rolls down sharply as you move from long- to short-term rates.
We usually see a steep curve when the market outlook is for stronger economic growth or rising inflation. Investors interpret the higher long-term rates as a sign that the market expects the Federal Reserve to raise interest rates in the future.
Flat Yield Curve
A flat curve occurs when the slope of the yield curve is very narrow, meaning there’s little difference between short- and long-term interest rates. When the yield curve is flat, it may signal that the market expects interest rates to stay relatively stable in the near future.
A flat curve can also indicate that the market is anticipating a period of economic stagnation. The curve generally becomes flat later in the economic cycle as investors expect an economic slowdown or if the inflation outlook is decreasing.
Inverted Yield Curve
An inverted curve is when short-term interest rates are actually higher than long-term ones. It’s a rare occurrence, and it sounds strange since a normal yield curve has higher long rates and a positive slope.
Historically, an inverted curve often occurs before a recession and usually after a period of increased interest rates by the Fed. An inverted curve isn’t a guarantee that a recession is imminent, but it is the market beginning to price in an economic slowdown.
What Drives the Slope?
The yield curve’s slope is constantly changing, ebbing and flowing, and becoming steeper or flatter. So, what determines the shape or slope of the curve? Three primary factors can cause the curve to steepen, flatten, or even become inverted.
One factor is the Federal Reserve’s monetary policy decisions. As the Fed raises or lowers interest rates, and the bond market anticipates and reacts to those moves, it will influence changes in the yield curve. The Fed’s rate decisions primarily affect the shorter end of the curve, usually out to about two or three years.
Another factor that influences the curve slope is inflation expectations. As I mentioned earlier, fixed-income investors will factor in the loss of purchasing power and want to be compensated for that risk. If the market anticipates a higher probability of inflation, then interest rates and the yield curve will adjust to reflect that scenario. And if inflationary concerns are diminished, that will also be taken into account.
Market Supply and Demand
The third factor that can affect the slope is the combination of bond market supply and demand. As bond issuance of different maturities changes over time, and as demand for those bonds fluctuates, it affects the price of the bonds, which in turn drives the rate or yield. As those conditions change, the rates represented on the yield curve will move accordingly, changing the slope of the curve in the process.
What Part of the Curve Matters?
As you might expect, yield curves and slopes get a lot of attention in the bond markets, mainly the Treasury curve. Because of that, it can be easy to get caught up in the latest financial headlines about the 10-year Treasury or other yield indices along the curve.
But here’s something to keep in mind. As you evaluate the curve and its slope, ask yourself – What part of the yield curve matters most to your financial institution?
If most of your institution’s earning assets are no longer than five years in terms of maturity or repricing, then why worry about what the 10-year Treasury is doing? The key is to focus on the part of the curve where your assets (including investments) and liabilities reside and base your asset-liability strategies and investment decision-making on your financial institution’s unique yield curve.
The yield curve is an essential tool for financial institutions to use to make decisions about their investment and balance sheet strategies. By understanding the factors that drive the curve and its slope, investors can better position themselves as market and economic conditions shift.
While no one can predict the future with certainty, by paying attention to how short- and long-term interest rates are changing, community financial institutions can do their best to stay ahead of the curve.
With everything that’s been going on due to the COVID-19 pandemic, especially in the financial markets, it’s made managing the investment portfolio for community financial institutions more challenging than ever. With that in mind, I want to tell you about an upcoming event that may be helpful.
The Graduate School of Banking at Colorado (GSBC) is hosting a three-part virtual learning series called “Investing During a Pandemic: The New Normal.” This is a free event that begins on Thursday, May 14.
I’m pleased to be one of the presenters in this virtual learning series for community bankers. In addition, Tim Koch from the Graduate School of Banking at Colorado and Jason Mork from Piper Sandler & Company will be speaking as well.
During the series, we’ll be discussing the impact of recent events on financial market conditions and how to craft investment strategies for financial institution portfolios. We’ll talk about interest rates and when to factor them into making investment decisions, as well as taking a two-pronged perspective to the investment portfolio. I’ll also be sharing three key elements to developing an effective investment strategy and four questions that you must ask as part of building that strategy. Finally, we’ll explore sound portfolio tactics when times get tough.
The virtual learning series begins on Thursday, May 14 and will run weekly for three weeks (5/14, 5/21, and 5/28). As I mentioned, this online series is free. GSBC is offering this and other programs as a service to community banks experiencing unprecedented challenges amidst the COVID-19 pandemic. To learn more and to register for the upcoming virtual series, click here. I look forward to seeing you online!