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Fed Funds Futures Give Hints Of Rate Changes

(Investor's Business Daily) -- A smart investor pays attention to changes in price and volume of his or her stocks and the general market. It also pays to monitor another key indicator that certainly affects stock prices: interest rates.

"Interest rates provide the best confirmation of basic economic conditions," wrote IBD founder and Chairman William O'Neil in "How to Make Money in Stocks."

The Federal Reserve can jump-start or hurt the economy by changing the fed funds rate, the interest rate that banks charge each other for overnight loans. Changes in fed funds rates have often marked the start of bull and bear markets.

Before the market topped in March 2000, the Federal Open Market Committee raised the fed funds rate four times from 4.75% in November 1998 to 5.75% in February 2000.

The FOMC raised it by an additional 25 basis points at its March 21, 2000, meeting and by 50 basis points at its May 16 meeting.

A week before the May 2000 meeting, fed funds futures signaled an 82% chance for a hike of 50 basis points.

While the fed funds rate has remained at a historic low of 0% to 0.25% since December 2008, there will be some point when the Fed's Federal Open Market Committee will have to raise rates. Investors can gauge the likelihood of such interest-rate changes by monitoring fed funds futures.

As Stan Dash, VP of Applied Technical Analysis at TradeStation, explained to IBD, the fed funds rate is the Fed's guidepost for at least short-term interest rates.

Futures contracts on the fed funds rate can tell you about the market's assessment of a possible change in the fed funds rate.

"The way the fed funds futures market is structured, the final value of a contract is based on the average fed funds interest rate during the delivery month," Dash said.

On May 11, the May 2012 fed funds futures contract gave a 62% probability of an increase in the fed funds rate to 0.50%.

"As we get different economic statistics, especially weak statistics in some of the employment numbers, we're seeing that (expected rate increase) being pushed out a little further," Dash said.

Since the Fed schedules eight meetings each year, it's possible to compute probabilities for rate changes around Fed meetings.

The formula to figure out rate-change odds is computed with a little algebra.

It involves solving for the probability once certain inputs such as implied fed funds rate (from futures prices), current fed funds rate, expected rate and the fraction of the month where a rate is known.

Investors can get the odds faster and easier having trading platforms such as TradeStation do the math for you.

The Chicago Mercantile Exchange's website shows changes in market expectations.