(Editor's note: This article is intended for professional investors.)
Summary: Shorting the Fed funds future currently offers a superior duration hedge and is worth consideration as a standalone investment due to its limited downside, great upside versus its margin requirement, and low cost of carry.
I wrote a prior article regarding hedging for long duration assets like PFF and LQD. The Fed funds future stood out to such an extent that it warranted more research. The Fed funds rate is the interest rate at which depository institutions actively trade balances held at the Fed. Banks that need to increase their required reserve balance will borrow from a bank with excess reserves at a market clearing rate. The March 2015 Fed funds future (FFH5) is in the sweet spot where it cannot lose much with extended low rates (7-15bps), but can have strong gains (60bps +) when ten year rates move to 3% or when the Fed discusses raising the target rate. Per $500 of margin this translates to a max USD loss of $333 - $625 and gains of $2,500+. The gains can happen without the target Fed funds being raised.
- They settle to the effective Fed funds Rate (FEDLO1 Index). The price is 99.85, and the rate is calculated as 100-99.85, so by going short the future you are going long the rate at .15%. During the tapering this rate shot up to over .6.
- To short one future requires a margin of $500, and 1 point equals $4,167. So the move during tapering would have made over $2000 per future. Downside would be futures going to zero, which is $625 (.15 * 4,167). The current effective Fed Rate now is .07. So status quo continuing is a $333 loss ((.15-.07) *4,167). This is a very cheap and effective hedge for higher yields due to the asymmetric payout profile.
Are Fed funds appropriate as a trading vehicle? A 2006 Fed Working Paper indicated excess returns on Fed funds futures using macro-economic signals, traded by non-hedgers: http://www.frbsf.org/economic-research/files/wp06-23bk.pdf. Some quotes (risk premia = excess returns):
- Given the short maturities and required holding periods to realize excess returns in the Fed funds futures market, one might think that risk premia in this market would be very small or nonexistent. We find that this is not the case.
- Traders that are classified as "not hedging" by the U.S. Commodity Futures Trading Commission went long in these contracts precisely when we estimate that expected excess returns on these contracts were high, and they went short precisely in times when we estimate expected excess returns were very low.
- …measures of excess returns on Fed funds futures…can be predicted using business cycle indicators such as employment growth.
Current Situation: the Fed target rate band is 0-25 basis points, versus the effective Fed funds rate of 7 basis points. The FFH5 is right in between at 15 bps. Any normalization to the upper range would give the position an added 10 bps, which is $416, on your $500 margin. This is a gain that would occur without the Fed fund target being raised, or inflation happening. It is simply the reversion to the historic equality between the effective funds rate and the target rate:
The white line is the target rate (.25), the colored line the effective rate (.07). This divergence started in September 2008, as a result of the Lehman failure. A lower Fed funds rate denotes a surplus of reserves, which was the result of money retreating out of Libor and money market funds into the safer federal funds, as well as the sharp increase of excess reserves in the banking system. There was less need to borrow Fed funds to meet reserve requirements so the volume and rates dropped:
So we are now close to the theoretical lows in the effective Fed fund rate at a time when trading volume is at its lows as well. The effective rate and Fed futures can move upwards quickly without news regarding the target rate. For example, In April 2013 the effective rate was 16bps and the 1 year Fed funds futures went to almost 76 bps. This is attributable to the taper news and the concurrent duration fears. Fed funds futures as a duration hedge passed this test with flying colors. The March 2015 future covers over 1 year of potential inflation news and monetary policy news, so its sensitivity is high. Here is how the Fed funds futures (white) did versus some other long duration investments during the two periods the 10 year rate increased in 2013:
Period 1 from (5/1/2013 to 9/15/2013)
Period 2 (12/10/2013 - 1/8/2014)
If FFH5 (.FFMARH INDEX) were included in the normalization, it would be off the charts due to the multiple 100 % increases. Also, if included in normalization it would mean that the margin invested in the FFH5 equals the principal in the other assets. Margin amounts are not subject to principal losses. The 100 max on the Fed funds futures is what allows me to consider the margin the principal, as max loss is smaller than the margin. Because of the Zero Lower Bound phenomenon, there is a unique chance to hedge/invest in an asset at its max capacity for further loss, while still having maintained its capability to move away from its lower bound.
Here is the complete relationship of FFH5 with the 10 year yield:
It is clear that when the 10 year yield is moving north, the FFH5 rates will move up more rapidly. Duration scare will increase the yield 4x and higher, and end of year balance sheet window dressing also increased it two fold. There is now a window where the 10 year yield backed off a bit and the Fed futures gravitated quickly back to the current effective rate:
We are currently at the most advantageous of curves in terms of going long the 1 year futures.
Fed Activity and the Fed Fund Rate: there are some minor Fed aspects I want to highlight that could affect the Fed fund futures. This also provides more background to Fed fund rate dynamics.
In the February Fed minutes release, "a few" members indicated "it might be appropriate to increase the federal funds rate relatively soon". Also the makeup of the Fed board is changing (Mester Replacing Pianalto, Kocherlakota dropped vote for lower rate) in that we may see more hawkish votes. If so, this would move rates upwards.
Furthermore, the Fed has started reverse repo operations, as a way to normalize the monetary system by draining excess reserves. In their study Arbitrage, liquidity and exit: The repo and federal funds markets before, during, and emerging from the financial crisis (http://www.federalreserve.gov/pubs/feds/2012/201221/201221abs.html), the Fed is projecting higher moves in the Fed funds rate than in the repo rate (page 54):
Just this week there were two reverse repos of 103.7bn and 130bn USD (2/25 and 2/26). Ultimately repo and Fed funds rate will converge, but in all scenarios the Fed fund rate will rise quicker and sharper than the repo rate. It's important to note that Fed funds are unsecured, and would price in credit deterioration more than repos, which are secured. In 2007 spread between repos and Fed funds widened dramatically as investors preferred the safety of secured overnight lending in repo. Theoretically a credit event could benefit this trade, despite the deflationary impact.
A final Fed catalyst would be addressing the gap between the 7bps effective Fed rate and IOER (interest on excess reserves) of 25 bps. This has existed because GSEs are unable to receive interest on reserves, so banks will borrow from them at the 7bps rate and arb with the Fed for 25bps. Policies might be put in place to address this differential (e.g. eligibility, higher reverse repo rates). Likewise, lowering the IOER would decrease the effective Fed rate as the arb shrinks.
These Fed specific catalysts need not happen to make this trade profitable. 2013 has shown that any increase in long term yields based on economic improvement and/or increased inflation expectations will suffice, despite anchored short rates.
Risks: Yellen just repeated that Fed funds cannot go lower than zero, although there is academic chit chat about negative rates. The Taylor rule would imply a negative funds rate is optimal policy. In the unlikely case this gains traction, it will most likely cover excess reserves, not required reserves.
Conclusion: This is a unique time to short Fed funds futures. Due to the zero lower bound on rates, downside is extremely limited and upside can be expressed as percentage of margin. Increases in yield and/or Federal Reserve normalization policies benefit this trade. For fixed income holders, this is an effective method to hedge duration risk.
Additional disclosure: I am short FFH5, the March2015 Fed fund futures