Interest Rate Jargons and Fed Funds Trajectory

ZQ1!

We are in a rising interest rate environment. But wait, which rate are you talking about?

All eyes are on the Federal Reserve. But could you really borrow money at the Fed Funds rate? If not, why is it a big deal? Most of us deal with different types of interest rates, such as those for bank deposit, mortgage loan, home equity loan, auto loan, credit card debt, student loan and business loan.

How are these rates determined? How are they related to the Fed Funds rate? Before you take out a loan or make an investment, it’s a good idea to gain some understanding of these questions. Our discussions mainly focus on US dollar interest rates.

Breaking Down an Interest Rate
According to Bankrate.com, the national average of 30-year fixed mortgage rate on October 8th is 6.89%. How is this rate calculated?

While all lenders employ elaborate methods to price an interest rate, I would like to introduce a simple formular to break down the rate into different components.
R(e) = R(rf) + D(p) + R(p) + L(p), where:
• R(e) is the effective interest rate
• R(rf) is the risk-free interest rate
• D(p) is a duration premium
• R(p) is the risk premium
• L(p) is the liquidity premium

Risk-free Interest Rate
Generally, we consider short-term U.S. government debts to carry zero default risk. Target Fed Funds rate is currently in the range of 3.00%-3.25%.

Duration Premium
US treasury debts have different durations, or the number of days till their maturity.
* Treasury bills (T-bills) are discount instruments maturing in one year or less from their issue date. T-bills are issued for terms of 4, 8, 13, 26, and 52 weeks.
* Treasury notes (T-notes) are interest-bearing securities that have a maturity between 1 and 10 years. T-notes are issued in 2, 3, 5, 7, and 10-year maturities.
* Treasury bonds (T-bonds) are long-term treasury securities issued with a 30-year maturity. Outstanding T-bonds have terms from 10 to 30 years.

While all Treasury instruments are free of default risk, longer-term notes and bonds carry a duration premium. The longer the term, the higher the rate.

We are in an inverted yield curve environment. US Treasuries are quoted and priced in yields. On October 7th, 2-Year T-Note is quoted at 4.312% while 10-Year T-note at 3.888%. The easiest explanation is that investors expect a recession on the horizon and interest rates to fall in the future.

Risk Premium
When a lender evaluates the default risk of a loan, they examine the borrower’s Character, Capacity, Capital, Collateral, and Conditions. These are called the “5 Cs” of credit.

In mortgage lending, 5Cs generally refer to the credit history, income, down payment, value of the house, and current housing market conditions, respectively.

The bigger the risk premium, the higher the interest rate. A subprime borrower with a 600 FICO score would pay higher rate than one with an 800 FICO. Someone who could put up a 25% down payment would get a lower rate than those with 10% down only.

In a booming housing market, a bank is willing to accept a lower risk premium. In the event of the borrower default, it could resell the house and likely get paid back in full.

Liquidity Premium
In the old days, when you got a 30-year mortgage from a savings-and-loans, it had to carry it on the book for the entire term. Since the loan was so illiquid, the lender had to charge a high premium to compensate for all the risks it took.

With the invention of the mortgage-backed securities (MBS), lenders could package hundreds of loans into MBS. As they recoup most of the capital quickly, they could make more loans and generate more fees. Readers who are interested in the history of MBS may check out Michael Lewis’ classic, Liar’s Poker: Rising through the Wreckage on Wall Street.

Mortgage loan applicants may find that Federal Housing Administration (FHA) loans carry a lower rate. If your loan meets FHA’s requirements, it would be guaranteed by the government agency. Therefore, it carries a lower risk for the lender. Additionally, FHA-conformed loans can be easily packaged into MBS, enhancing their liquidity.

The Importance of Reference Rates
When a lender prices an interest rate, it usually employs one or more reference rates. If you carry a credit card balance, you may notice that interest charges vary monthly.

Look up the Customer Agreement with the credit card issuer, you would likely find them defining the Annual Percentage Rate (APR) as “prime rate + xx%”.

Typically, the mark-up portion on the right is fixed for contract terms. However, prime rate is usually defined as “Fed Funds + x%” and may be updated monthly or weekly.

If your credit card says APR = prime rate + 12% and Prime Rate = Fed Funds + 3%, you will be paying 18.25% (= 3.25+3.00+12.00) on outstanding balance, accrued daily. If the Fed raises rate by 75 bp next month, you will find the APR jumping to 19%.

Most lenders use reference rates. With Fed Funds being the root of rate calculation, every Fed rate decision would cause a repricing of the entire credit market. Fed Funds rate is the most important interest rate benchmark in the world. This is why we call it the “Mother of All Reference Rates”.

If you do not wish to iterate rate calculations step-by-step, other references may provide easy solutions. For example, a small-town savings-and-loans could set its deposit rate at the Secured Overnight Financing Rate (SOFR) SR11! , and mortgage rates at 5 basis points over the national average rates published by Mortgage Bankers Association.

Rate Trajectory Projected by Fed Funds Futures
CME 30-day Fed Funds Futures ( ZQ1! ) are directly linked to Fed Funds rates. Keeping up with T-bill market conventions, they are quoted like a discount instrument, 100 – R. Interest rate of 3.25% will be converted to a market quote of 96.75 (=100 – 3.25). If you ever wonder why, this is because short-term rate products do not make periodic coupon payments. Instead, you buy at a discount and get the par value back at maturity.

ZQ has monthly contracts going out for five years, with good liquidity for the first 1-1/2 years. It is a reliable measure of what investors think the Fed Funds rates would be in the future. Based on ZQ settlement prices as of October 7th, we get forward Fed Funds Rates implied by the futures market as follows:
• OCT 2022: 3.080%
• NOV 2022: 3.755% (+67.5 bp)
• DEC 2022: 4.110% (+35.5 bp)
• MAR 2023: 4.610% (+55.0 bp)
• JUN 2023: 4.635% (+2.5 bp)
• SEP 2023: 4.580% (-5.5 bp)
• DEC 2023: 4.435% (-14.5 bp)
• FEB 2024: 4.365% (-7.0 bp)

The above quotes show where futures market expects rate hikes to end in Mid-2023. They also expect Fed Fund rate to go down immediately afterwards.

Last Wednesday, in an interview with Bloomberg TV, San Francisco Federal Reserve Bank President Mary Daly called out such projections as inaccurate. She said that the Fed would like the rate to be restrictive enough (4.5%?) and to stay there for a while until inflation is back to the 2% policy target.

Mispricing in the outer months may be a good trading opportunity. Just remember, if you think the implied rate in December 2023 is too low, you would short ZQ futures. This is because of the 100 – R pricing convention. A bigger R would result in a smaller 100 – R.

Financial market is extremely volatile this year. Getting an information edge increases your odds of success in managing risk. I suggest leveraging real-time market data for a better gauge of market situation. TradingView users already have access to delayed data. A Pro user could upgrade to real-time CME market data for only $4 a month, a huge discount at the time of high inflation.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.