Money-market derivatives signal traders expect the Federal Reserve will most likely lift its target rate for overnight loans between banks in the second quarter of 2013, according to Credit Suisse Group AG analysis.
The chance the Fed will begin raising borrowing costs as early as 2012 is 12 percent, while an initial increase in 2013 or 2014 each carries a 24 percent probability, Credit Suisse analysis using a gamma probability distribution of forward overnight index swap rates shows.
Treasury yields surged and money-market rates rose after Federal Open Market Committee members raised their assessment of the U.S. economy on March 13 while reiterating that borrowing costs would probably stay low through at least late 2014. The policy statement led money-market derivative traders to bring forward the time when they predict the Fed will first lift its target of zero to 0.25 percent.
“If you take the pricing in the futures market at face value, it shows a gradual increase in the fed funds rate starting in 2013,” Carl Lantz, head of interest-rate strategy at Credit Suisse Securities USA LLC in New York, said in a telephone interview today. “However, the futures only show an average of many possible paths for fed funds. Our model and the use of the gamma distribution allow us to tease out the implied path that is most likely.”
The implied speed of increases is 0.29 percentage point per quarter, with the Fed’s target rate rising to 3.86 percent by the end of the tightening cycle, according to Credit Suisse’s analysis using the statistical method, which is commonly applied to predict when an event will happen.
The more conventional methods of observing Fed rate expectations, which require the binary choice of either an increase or no increase, using overnight index swap rates or federal funds futures, is flawed at present in part because the longer contracts are less liquid, according to a note published March 23 by Lantz and Eric Van Nostrand, a Credit Suisse interest-rate strategist. The use of options on fed funds futures, which provides the ability for a range of probabilities, is also lacking for the same reason.
“Official Fed policy suggests a long pause followed by a tightening cycle,” Lantz and Van Nostrand wrote. The conventional interpretation of “market pricing seems to expect the first hike on a relatively shorter timeline followed by an unusually gradual tightening cycle,” they wrote.
Overnight index swap rates are over-the-counter derivatives in which one party agrees to pay a fixed rate in exchange for the average of a floating central-bank rate over the life of the swap. For U.S. dollar OIS, the floating rate is the daily effective federal funds rate, which was 0.14 percent yesterday.
Fed funds futures, which were first offered on the Chicago Board of Trade in October 1988, show what traders bet the fed funds effective rate will average over the life of the contract. The implied yield on the November 2013 contract is 0.35 percent. That’s up from an implied rate on the contract of 0.19 percent two months ago.
The fed funds effective rate is a volume-weighted average on trades by major brokers published by the New York Fed with a one-day lag.
The Credit Suisse model also uses forwards on the gap between the London interbank offered rate and OIS, known as the Libor-OIS spread, derived in part from the Chicago-based CME Group exchange’s Eurodollar futures contracts. These futures are based on expectations for three-month dollar Libor, fixed daily by the British Bankers’ Association.
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