Funds News

Drop in futures use signals Fed rate level uncertainties

NEW YORK, Dec 8 (Reuters) - Declining activity in the U.S. federal funds futures market in recent weeks may signal doubts whether the Federal Reserve will be able to achieve a higher target range when it decides to end its near-zero interest rate policy.

The Fed is expected to raise rates next week. But traders worry whether it has enough policy tools to siphon some of the $2.5 trillion in excess reserves from the banking system to control short-term borrowing costs.

Since October, total open interest on fed funds futures has fallen 27 percent. This contrasts with the pickup in demand and participation in the fed funds futures market in advance of the Fed’s prior two rate-hike cycles that began in 1999 and 2004, respectively.

“People are wondering how accurate it’s going to be,” said Chuck Retzky, director of futures sales at Mizuho Securities USA in Chicago.

Fed policymakers have expressed confidence they have a system of tools to manage interest rates. But while the programs have been tested, doubts persist whether they will be adequate for the Fed to reduce enough reserves to move short-term rates higher.

Futures contracts on overnight borrowing costs on fed funds allow traders and investors to hedge short-term interest rate risks. Since late October, open interest has dropped to 662,350 contracts from 926,679 contracts, while the number of players who trade those contracts dropped to 98 from 131, according to the latest data from Commodity Futures Trading Commission.

The Fed adopted a zero-to-0.25 percent target range in December 2008 at the depths of the global financial crisis.

The effective or average fed funds rate has been 0.10 percent to 0.15 percent so far this year. Analysts forecast the Fed’s target range would move up to 0.25 percent to 0.50 percent.

The Fed has signaled it would stick with a rate target range once liftoff occurs. It would use the interest rate on excess reserves (IOER) as the “ceiling” rate and the interest rate on fixed-rate reverse repurchase agreement (RRP) as the “floor” rate.

The IOER rate is currently 0.25 percent and RRP rate 0.05 percent.

“There are a lot of concerns that the Fed won’t hit its target range after liftoff,” said Alex Manzara, vice president of institutional sales at R.J. O’Brien and Associates in Chicago.

Goldman Sachs, in a note published last week, said the Fed has additional options if the use of the IOER and RRP are not enough, including raising the cap on the reverse repo facility to meet demand at a higher rate, or increasing IOER.

Fed funds futures on Wednesday implied traders priced in an 87 percent chance of a rate hike next week, up from 83 percent on Tuesday, according to CME Group’s FedWatch program.

“When the fed fund futures price implied rate moves that are in line with FOMC guidance and market participants’ views, some participants may close out their positions,” a CME spokesman said of the recent fall in open interest and position holders. (Reporting by Richard Leong; Editing by Dan Grebler)