Summary

This is a cheap form of insurance against a variety of macro-economic uncertainties (the most obvious being inflation) which could otherwise hurt a portfolio of value investments.  As a result of a challenging backdrop for US monetary policy, Fed Funds futures expiring in December 2014 imply a yield which is probably too low: 0.70%.  The FOMC themselves project the most likely rate to be 0.75% by then, and members forecast a wide range of possibilities from 0.00% to 2.75%.  Given the uncertainty facing monetary policy, inflation and economic growth, and the asymmetric payoffs provided by the ability to limit losses from the short to 0.70% because Fed Funds futures will almost certainly not settle above par (0.00% yield), shorting these contracts represents a compelling special situation which could enhance the risk/reward profile of a long US stock portfolio.

Outline

Below I attempt to answer the following questions:

1. What is the idea?
2. Is this a value investment?
3. Is it cheap?
4. Why is it cheap?
5. Why us?
6. Why this contract?

Terminology: As a fixed income product, references below (such as “cheap”) are on a yield basis unless specified.  On a price basis it would be inverted.

What is the idea?

Short Fed Funds Future Dec 2014 expiry (ticker: FFZ4) at 99.30 (0.70% implied yield).

Contract specification: “100 minus the average daily Fed Funds overnight rate for the delivery month (e.g., a 7.25 percent rate equals 92.75).”

http://www.cmegroup.com/trading/interest-rates/stir/30-day-federal-fund_contract_specifications.html

In basic terms, this contract will probably settle at 100 minus the Fed Funds target rate in December 2014, despite the contract specification referencing the Fed Funds overnight rate.  A more detailed description is included below, but feel free to skip this section and start reading again at “Is this a value investment?”

The Fed Funds overnight rate - also known as the effective rate - is calculated by the Federal Reserve Bank of New York and is the volume-weighted average of interest rates at which depositary institutions lend to each other overnight. 

The Fed sets monetary policy mainly by announcing a Fed Funds target rate.  (Lately they have been experimenting with other unconventional tools as well).  While the market determines the effective rate, with significant intra-day and intra-month swings, the Fed has a pretty good track record of keeping theses deviations evenly balanced so that the average effective rate in a given month normally tracks very closely to the Fed Funds target.

 “By trading government securities, the New York Fed affects the federal funds rate, which is the interest rate at which depository institutions lend balances to each other overnight. The Federal Open Market Committee establishes the target rate for trading in the federal funds market.”

http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm

The Fed Funds effective rate is currently 0.12% (or 12 basis points, “bps”).  The Fed Funds target rate is currently (and unusually) a range, of 0.00-0.25%.  This derivative contract should be one of the best ways of making a bet on future monetary policy, uncorrupted by the influences of bank credit (which features heavily in similar contracts like Eurodollar futures) or the supply and demand of government bonds.

Historical changes in the Fed Funds target rate can be found here:

http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html

For readers who need the stimulation of profit potential during an otherwise dry read, please focus on the two tightening cycles which followed other periods of very easy/low monetary policy: starting in February 1994 when the Fed Funds target was raised 300 bps from 3.00% to 6.00% within a period of less than 12 months, and starting in June 2004 when it took 2 years to raise rates by 425 bps from 1.00% to 5.25%.

Is this a value investment?

"An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

Graham and Dodd, 1934.

This idea is not a classic value investment.  It is a derivative contract whose settlement price will be largely controlled by central bank policy, and it will expire in December 2014.  If the Fed Funds target rate is unchanged from current levels, this contract will lose money.  Some would even consider it a speculation, since any one of a number of events needs to occur within a fixed time frame for it not to lose money.  However I think that that there are good reasons why value investors might consider this a useful addition to a long stock portfolio since it represents a form of cheap insurance against several macro-economic scenarios which could otherwise prove damaging to the intrinsic or quoted value of other value investments.  I’ll leave the exact definition up to the English/Philosophy majors.

Is it cheap?

I consider the current valuation of 70 bps (100 minus the 99.30 price) to be cheap on a yield basis (or rich on a price basis).  Since valuation is the central issue and very different in methodology from valuing a common stock, I will describe several valuation prisms through which we could view this contract’s price.

1. Expected value
2. Time value
3. Volatility
4. Historical comparisons
5. Economic models

a.  Expected value

Asymmetric payoffs:  This contract is a futures contract that will settle to a fixed price in 2 ¾ years time.  However, due to current yields being so low, and the unlikelihood of yields going negative, a “zero bound” creates an asymmetry in future payoffs.  Simply: yields can go up a lot, but down only very little. 

The reason for the zero bound: Note that yields could conceivably become negative.  Short-term government bonds have in some countries traded for negative yields during the credit crisis – but the utility of government bonds (as collaterol or bank capital) is very different from the bank deposits underlying this derivative contract.  Nevertheless, in these experimental times for monetary policy, I suppose that there is a chance that the Fed introduces a negative Fed Funds target rate.  However there are many practical obstacles to this policy, which is partly why controversial alternatives such as quantitative easing have been used instead, since forcing banks to pay someone else to hold their deposits would be quite hard to implement.  Furthermore:

“Fed funds are not collateralized. Like eurodollars, they are an unsecured interbank loan.”

http://blogs.wsj.com/economics/2007/08/20/discount-window-vs-fed-funds/

This means that as long as banks remain profit-seeking institutions, a negative Fed Funds target might not translate into a negative Fed Funds effective rate.  I suspect that Jamie Dimon would prefer hiring a warehouse in Brooklyn and some men with big guns before he pays Citibank a few percent of principal for the privilege of depositing his banks’ excess cash overnight with full counterparty risk.  Bottom line: the zero bound should exist for the Fed Funds effective rate in most scenarios.  The probability of it trading negative for one month would seem to be a small fraction of one percent.

Cheap optionality: This asymmetry creates a payoff structure that looks like an option.  However the presence of optionality is insufficient to prove cheapness, since obviously options can be expensive.  In this case the “option premium” should be reflected in an implied futures yield which is a little higher than the most likely outcome, to compensate for the asymmetry.  The most likely outcome can be determined in several ways.  The simplest is perhaps to look at what the 17 FOMC members themselves think that this contract will settle to in December 2014.  Since January 25^th, 2012, we have this information as the Fed began publishing an overview of FOMC participants' assessments of appropriate monetary policy for each of the next three year-ends.  See Figure 2 of the following link, or my summary table below:

http://www.federalreserve.gov/monetarypolicy/mpr_20120229_part4.htm

Source: Fig. 2 http://www.federalreserve.gov/monetarypolicy/mpr_20120229_part4.htm

The median forecast is the most likely (but highly uncertain) outcome: During the press conference following this release, Chairman Bernanke explained that these current forecasts from the 17 FOMC members could change over time and that future monetary policy decisions will be made collectively.  But based on the information the FOMC currently possesses, their median forecast seems to be the most likely outcome, as Bernanke himself confirmed in response to the question: “If I were to draw a line through this—these dots, how should I draw it so I best understand what the FOMC is most likely to do?”

“If you want to draw lines, I guess I would—I guess my suggestion would be to look at the median, the middle of the distribution, because we do have a democratic process in the Committee, and so the median would give you some sense of where the weight balances against higher—in favor of higher or lower rates.”

http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20120125.pdf

This contract is valued below the most likely outcome, but the presence of optionality should make it trade higher.  Valuation is therefore a discount to fair value: If 0.75% is the most likely outcome, then an asymmetric payoff structure due to the presence of the zero bound should include some premium, i.e. fair value should be higher than 0.75%.  Instead the contract trades at a slight discount, at 0.70%, with no apparent premium for the asymmetry.  The mean value for the above distribution is 1.03%, which might give a better sense of the expected value.

Clearly the presence of a mode (or most common forecast) of 0.00-0.25% (i.e. unchanged monetary policy) which probably includes the Chairman’s vote, might affect future voting and therefore pricing.  It is therefore important to consider how this might change with time. 

b. Time value

“Mr. Chairman, how much confidence do you have in the FOMC’s ability to forecast the economy and inflation out three years? And consequently, how much confidence do you have in the interest rate projections that the Fed has made public today, particularly the ones that go out to 2014 and beyond?”

“(O)ur ability to forecast three and four years out is obviously very limited, there’s no question about that. Nevertheless, we have to make a best guess, a provisional plan, in the same way that a firm making an investment has to make a best guess or provisional plan about where the economy and the industry is going to be over a number of years. And so it’s certainly possible that we will be either too optimistic or too pessimistic, in which case we’ll have to adjust both our forecasts and our policy expectations.

And I guess I might add to that, you know, the Chairman’s term is not infinite and at some point there’ll be a new Chairman, but there’s a lot more continuity on the FOMC collectively. The average Bank president is on the FOMC for as much as 10 years and Governors’ terms are 14 years. So even as the Chairman changes, much of the FOMC remains continuous. So, as we talk about interest rates in 2014, the fact that there is quite wide-ranging agreement that interest rates will be low for a long time, should give you more confidence that that’s not dependent on a single individual.”

http://www.federalreserve.gov/mediacenter/files/FOMCpresconf20120125.pdf

• This derivative contract has 2 ¾ years to run.  That is a long time in financial markets and the economy.  Many different macro scenarios could prompt the Fed to adjust policy if necessary during that period.
• Bernanke claims that his view does not dominate the FOMC.  Nevertheless the Chairman’s second term will end on January 31^st 2014, and it is possible that there will be a new President of the United States by then, who could nominate a new Chairman of the Federal Reserve.  Even if Bernanke himself does not lead a change in rates before his second term ends, if he does get replaced as Chairman in January 2014 by whomever is President at the time, there should be six scheduled FOMC meetings between then and the futures contract’s expiry in December 2014.  The distribution of FOMC members’ votes for appropriate monetary policy by the time 2014 actually comes around could therefore be very different to current expectations.
• This derivative contract therefore covers a period of great uncertainty – in the economy, in US Politics, and in the composition of the FOMC itself.  During a period of uncertainty, cheap optionality is a good thing to own.

c.  Volatility

Historical volatility over just the last 30 days illustrates the value of optionality during periods of uncertainty.  As the US economic situation unfolds with each new piece of data, the contract has traded between 99.32 (yield of 0.68%) and 98.84 (1.16%) for a 48 bps move up in yields followed by a 46 bps move down.  These are significant short term moves when compared to a maximum downside of 70 bps over 2 ¾ years if the zero bound is not breached.

If we look back further than one month, the scope for uncertainty becomes even more apparent.

d.  Historical comparisons

2 ¾ years is a long time in monetary policy: If in January 2006 the FOMC members had published their forecasts for monetary policy over the next 3 year-ends, presumably their forecasts would have clustered around a median of at least 4.25%.  That was the Fed Funds target rate at the time, and the FOMC were in tightening mode, continuing further rate hikes up to 5.25% in June of that year.  So the January 2006 median forecast of the December 2008 target rate would probably have been at least 4.25%.  The actual outcome was instead 0.25%.  I have obviously cherry picked this example, no doubt to the cries of “unprecedented!” around the room.  But I hope it illustrates that the Fed, just like us all, can get long-term projections wildly wrong.   

The FOMC says that in the “longer run”, the Fed Funds target should be 4.13%: The January 2012 FOMC economic projection which included the median December 2014 forecast of 0.75% referred to above, included the median projection for an undefined “longer run” of 4.13%, with all 17 members thinking this should be at least 3.75%.  Simultaneous to making a highly influential projection that rates will remain exceptionally low for the next 2 ¾ years, the FOMC thus acknowledged this to be significantly lower than where a longer term “normal” rate should be.  Therefore it would appear reasonable for the market to assign at least some probability to the scenario that economic conditions will have normalized sufficiently by December 2014 to warrant a target rate which more closely resembles this “longer run” one.  A young child would no doubt point out my inconsistency in planning to gorge on chocolate for the next few years if my long-term goal were to get slimmer.

Current market predictions for 2014 yields are extremely low when compared to a long history:  Although this specific contract has only been traded on the CME since December 2011 (low yields and volatility have prompted the CME to extend the yield curve covered by Fed Funds contracts; previously Fed Funds contracts this far out were not available on the exchange), other forms of forward US interest rates for the year 2014 have been traded over-the-counter since the 1980s.  Current market expectations are within 16 bps of the lowest that they have ever traded during the past three decades.  That covers the significant macro events of 1987, 2001 and 2008.  Clearly we now possess the valuable news that “economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

http://www.federalreserve.gov/monetarypolicy/fomcminutes20120125.htm

This is obviously the dominant reason why current market consensus is so different to the historical consensus.  Nevertheless, it is worth reminding ourselves that what now might be considered normal is historically extremely rare.  It might even sound eerily reminiscent of the “this time is different” scenario of very low credit and mortgage spreads of 2005-06, when somewhat similar asymmetries were presented in macro products.

e.  Economic models

Various economists try to predict the quantitatively appropriate level of the Fed Funds target rate.  Perhaps the best known is the Taylor Rule, named after John Taylor of Stanford University.  According to Bloomberg, his rule (using discretionary inputs) suggests the current Fed Funds target should be 0.65%.  18 months ago this model’s output was negative 2.00% which shows how quickly the economic landscape can change.  If the following inputs change over the next few years, the model would suggest a higher rather than lower Fed Funds target (in order of perceived probability): lower unemployment, higher inflation, higher NAIRU (non-accelerating inflationary rate of unemployment) or higher neutral real rates.  Plugging the FOMC’s mid-points of their central tendency economic projections for December 2014 (core PCE of 1.8% and 7.15% unemployment) would give a model target rate of 1.55% in December 2014.

Valuation summary: the market consensus for December 2014 interest rates seems too low relative to history and economic models.  Given the asymmetry created by the zero bound for rates which should limit losses to a maximum of 70 bps and relative to the amount of time value and uncertainty to be encountered before the contract settles, the contract is cheap.

Why is it cheap?

As conventional monetary policy became ineffective due to the zero bound (the Fed could not cut rates any further even when economic conditions suggested that further monetary easing was necessary) various unconventional monetary policy tools were employed.  All of these had been researched over many years as central bankers considered Japan’s unfolding economic problems and perceived central bank impotence during the 1990s, and US central bankers worried about the threat to their own abilities to prevent deflation should such a scenario ever occur in the US.  Starting in August 2011, the Fed explicitly referenced in its FOMC statement a conditional commitment to keep rates low until mid 2013. 

“The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”  

http://www.federalreserve.gov/newsevents/press/monetary/20110809a.htm

This timeframe was controversial even among FOMC members, but was extended yet further in the January 25^th, 2012 meeting :

“…currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

http://www.federalreserve.gov/newsevents/press/monetary/20120125a.htm  

This rhetoric is a form of unconventional monetary policy easing.  It is very clearly explained in FOMC minutes as being conditional on future economic developments:

“Some members underscored the conditional nature of the Committee's forward guidance and noted that it would be subject to revision in response to significant changes in the economic outlook.”

http://www.federalreserve.gov/monetarypolicy/fomcminutes20120125.htm

However since this rhetoric is a form of monetary policy, the Fed should be happy to keep the yield curve lower than an expected value analysis might indicate until they are convinced that either inflationary pressures or the economic recovery is sufficiently strong that a slight tightening of monetary policy could be withstood.  Therefore I would expect Fed rhetoric to continue to keep this contract somewhat under-priced unless or until economic data changes their mind.

In one sense, the Fed itself is providing this cheap optionality, since it meets its purposes in setting monetary during an extraordinarily difficult time.  In many ways if future conditions warrant higher interest rates then the Fed would be relieved, and certainly have more ability to raise rates into that environment than they would have to ease monetary policy if economic conditions deteriorate.  Notice the language in the November 2011 FOMC minutes, which describes the Fed’s own policy asymmetry (which with some thought can be seen to be the mirror image of this contract’s payoff asymmetry), since monetary policy is simpler and more effective into a stronger economy/inflationary environment than vice versa:

“Given the potential pitfalls of pursuing commitment strategies extending far out into the future, many participants thought that the Committee should consider policies intended to accrue some of the gains from conditional commitments and to perform well in a wide range of alternative scenarios. In this vein, a number of participants expressed support for the possibility of clarifying the conditionality of the Committee's forward guidance about the trajectory of the federal funds rate through setting numerical thresholds for unemployment and inflation that would warrant exceptionally low levels for the policy rate.”              (Emphasis added).

http://www.federalreserve.gov/monetarypolicy/fomcminutes20111102.htm

Thus the cheap optionality is being provided by the Fed, since they want to hedge against uncontrollable deflation at all costs, because conventional monetary policy would be ineffective from the zero bound and unconventional tools might not work, whereas in comparison the Fed should be quite comfortable facing a stronger economy or inflation with conventional and powerful monetary policy tools.

Why us?

VIC members might be interested in this idea as it could work in two ways.  Firstly, as valuation gets really extreme it simply underprices uncertainty.  I think that has started to happen, but clearly the contract price could continue towards par and present a more and more compelling short.  As uncertainty gets underpriced, so random events, rather than accurate economic forecasts, could make this idea work.  Value investors can examine the current undervaluation of uncertainty without the emotional baggage of cumulative losses from an early or wrong specific macro-forecast.

The second way in which it could work is as a cheap inflation hedge.  Seth Klarman of Baupost spoke at a Columbia Business School conference on October 2, 2008 about the potential benefits of inflation hedges:

"We do not use macro views, yet when we hedge, we will use a macro view. We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don't own gold as a commodity. We won't disclose our inflation hedge, yet with enough work, you can find true inflation hedges."

http://safe-and-cheap.blogspot.com.br/2008/12/seth-klarmans-inflation-hedge.html

I think this is a very simple cheap, inflation hedge.  There is very little basis risk such as can be found in many alternatives.  The downside risk can be tightly quantified, whereas many inflation hedges contain no optionality and could lose almost an unlimited amount of money if inflation does not happen.   Those kind of inflation hedges should only be put on when one feels very confident about an inflationary threat, which is typically more of a macro call made by macro specialists.  For value investors who might be mildly concerned but far from certain about inflation, this kind of cheap protection might be especially valuable.

During the 3 ½ years since Klarman made the above statement inflation has been volatile but contained, with US Core PCE currently at +1.9%.  However that is already close to the Fed’s inflation target of 2.0%, and is even more strikingly close to the January 2012 FOMC forecast of each of the 17 FOMC members who picked 2.0% as the upper end of their forecasted range for Core PCE inflation for each of the years 2012, 2013 and 2014.  No-one in the FOMC is therefore anticipating inflation to breach its 2.0% target anytime in the next three years, which is a big reason why the current extremely accommodative monetary policy is believed to remain so appropriately low for so long.  This seems a little overconfident to a foolish macro ignoramus like me.  Real (i.e. inflation-adjusted) monetary policy has been negative for 3 ½ years already, is projected as being negative for another 2 ½ years, monetary policy is known to operate with lags, and yet there is no risk that inflation picks up? This could be correct.  But even a slight pick-up in inflation over the next couple of years could have a meaningful impact on market expectations for future interest rates.  If some extreme event caused core PCE growth in future to rise say to 2.7% or more, which does not seem completely incredible since that would be “just” 0.8% faster than the trailing twelve month rate of 1.9%, that would mark the highest level for the past two decades of this key inflation indicator.  I suspect that would cause a very large move in interest rate expectations from here, and would escalate a whole new debate about the appropriateness of current monetary policy.  I have little reason to believe that this extreme scenario will happen.  But it might.  And given the potential negative impact such a scenario could have on US value investments (earnings or market valuations could be significantly harmed), I think the cheap cost of this protection makes it very relevant to the value investor.

Why this contract?

Fed Funds contracts are currently quoted out to March 2015, this contract month was picked just for illustration against specific December 2014 economic projections from the Fed. Similar but slightly different risks are embedded in any US interest rate product, traded on exchanges or OTC.  Long dated Fed Funds contracts currently have much lower Open Interest than the ultra-liquid Eurodollar futures, though these contain additional basis risks between monetary policy and 3 month bank LIBOR rates to which they settle.

Other risks and Disclaimer

Liquidity – currently thinly traded these contracts should improve their depth as they approach maturity.

Exchange traded risks – margined exchange traded product.

This is not investment advice and is not intended to be distributed in any jurisdiction where it would contravene local laws.  The author or his affiliates might have a position in the above securities that could be changed at any time without further reference to this board.  The above opinions are not recommendations, and the author accepts no liability for any use of the above.