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Weekly Economic Letter

Options on fed funds futures: a powerful forecasting tool

Mon, Nov 20 2006, 18:12 GMT
by Economic and Strategy Team

National Bank of Canada  |  View company's profile

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Summary

• Before 1988, the tool kit available to market participants to manage the risks associated with changes in monetary policy was limited. To deal with this deficiency, in January 1988, the Chicago Board of Trade (CBOT) introduced a new product: federal funds futures contracts.
  
  
• In addition to their function as a risk management tool, fed funds futures also provide important information about the market’s expectations regarding changes in monetary policy.
  
  
• However these contracts only provide a summary view. They do not tell us much about the choices available to the central bank or about the odds the market gives them.
  
  
• CBOT’s introduction of options on fed funds futures contracts in March 2003 widened the range of tools for managing risk and for taking a position directly on a wider range of potential Fed actions.
  
  
• Options on fed funds futures also enable the seasoned observer to measure precisely the probability attributed by the market to each potential outcome.

Weekly indicators

United States – Retail sales fell by 0.2% in October. Excluding autos, sales were down 0.4%, much worse than the 0.2% expected. Gasoline stations again took their toll on the headline figure. Excluding energy spending, total sales were actually up 0.4% on the month, the fourth consecutive monthly increase. Excluding autos and gasoline, sales were up 0.3%, also the fourth increase in a row. In inflation adjusted terms, retail sales were revised up from 3.3% to 3.9% in Q3, suggesting an upward revision to Q3 spending. The headline CPI fell by a largerthan anticipated 0.5% in October partly due to a 7% drop in energy products. As a result, year-over-year CPI inflation was down to 1.3%, a significant improvement from the cyclical high of 4.3% hit four months ago. The core rate was up only 0.1% on the month, the smallest increase since August 2005. On a year-over-year basis, core CPI inflation edged down to a three-month low of 2.8%.

Canada – Factory shipments plunged 3.3% in September, after a downwardly revised decline of 0.7% in August. Shipments were off in 13 of 21 manufacturing industries, representing over three-quarters of shipments. The largest contributors to September’s drop were petroleum & coal products (-15.3% with prices -13.8%) and automotive products (- 7.1%). New orders declined 2.8%, again led by petroleum & coal products and automotive products. Unfilled orders declined 0.9%, major contributors being motor vehicles (-21.5%) and primary metals (-11.2%). Inventories were up 0.6%, so the inventory-to-shipment ratio gained 0.5 to 1.32, the highest since January 2004. In constant dollars, shipments were down 1.2% in September, after a downwardly revised 0.1% in August. According to the Canadian Real Estate Association, the number of homes sold via the MLS in Canada’s 25 major markets was up 0.1% in October, the same increase as in September. On a seasonally adjusted basis, the increase YTD is 0.2%. The average price of homes sold reached $304,476 in October, a 9.6% increase over a year ago.

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Published on  Mon, Nov 20 2006, 18:15 GMT

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