The Federal Funds Rate is the overnight interest rate at which one bank lends funds held at the Federal Reserve to another bank. The Federal Open Market Committee (FOMC) establishes a target rate for trading in the federal funds market. The target has been set from 0.00 to 0.25% as of December 16, 2008. Every day the Federal Reserve measures and publishes the previous day’s effective federal funds rate known as the daily effective federal funds rate.

“The daily effective federal funds rate is a weighted average of rates on brokered trades.” [Source].

The FOMC meets periodically throughout the year to determine and announce the Federal Funds target rate. The next meeting is December 15/16th, 2015. Everyone knows the Fed is going to increase the Federal Funds rate target, but no one is certain when. There is a lot of speculation that the target rate will increase on December 15/16th.

Let’s see if we can draw some insight on when they are going to raise the rates by looking at the EUR/USD 1-day chart, and the daily effective federal funds rate, from before the FOMC changed the target rate on December 16, 2008 from a target of 1% to a target of between 0.00 and 0.25%, where it has remained since.

What Happened to the EUR/USD Last Time?

(Source: TradeStation II (EUR/USD 1-Day)

A couple observations:
• It looks like the markets got a bit volatile and choppy in the couple months leading up to the interest rate target change. Note that the Average True Range (ATR) indicator spiked from .010 to over .035.
  • Also remember this was a turbulent time- the Fed not only decreased the target rate on December 16th, but also reduced it on October 29th, October 8th and April 30th.
• The market participants anticipated the interest rate target decrease. The USD started to depreciate against the EUR 8 days before the interest rate decrease was announced. This makes sense; an increase in the interest rate implied that the USD was weakening and needed a boost.

Now let’s see if either of these observations are present in today’s market.

What Is Happening Now?

Let’s take a look at the EUR/USD over the past few months to see if there has been a spike in volatility (using the ATR) and/or if the USD has begun to depreciate against the EUR.

• Market volatility: The market is not particularly volatile. It looks like there was a small spike a few days ago and today (12/09/2015), but in general, volatility has been on a downtrend the past few months. Additionally, the ATR is at about .01; nothing to get excited about.
• Has the USD appreciated against the EUR ~5 - 10 days before the interest rate rise? It could be a bit early to tell, but it is pretty clear that the EUR has actually appreciated against the USD in the past few days.

These two observations do not lend any evidence to confirm that there will be an interest rate rise on the 16th. Let’s take a look at another variable, the daily effect interest rate to see if we can see any evidence of an upcoming interest rate increase.

What Happened to the Daily Effective Rate Last Time?

The daily effective federal funds rate is a weighted average of brokered trades on overnight interest rates between banks. In other words, the Fed sets a target and the daily effective rate is the actual rate measured in the market. Let’s look at the daily effective interest rate percent decrease over the same period and see if we can extract some general guidelines like we did with the EUR/USD 1-day chart.

General guideline and what to look out for that might signal a change in the interest rate target:
• Daily effective rate was volatile and on a downtrend in the months leading up to the interest rate change. We’ll want to look for a volatile daily effective rate and an uptrend this time around.
• Percent change in daily effective rate from day-to-day is relatively choppy and volatile in the couple months leading up to the rate change.

What Is Happening Now?

Let’s take a look at the same variables from the months leading up to today:

• The daily effective interest rate is pretty much flat. The movements are regular and predictable. Additionally, there is no trend.
• The percent change is relatively volatile (those are some big jumps!) but they are regular and predictable as well.

Before writing this article, I would have said the Fed was going to raise the interest rate target on the 16th. After diving into the EUR/USD and the daily effective rate, I would say that the Fed is going to wait until January to raise the interest rate target.

EUR/USD is not behaving as I would expect (USD appreciation against the EUR) and low volatility and the volatility in the percent change in the daily effective rate from day-to-day is relatively flat and regular, suggesting the market doesn’t expect a change.

It is still a bit early to tell so we will see what happens in the next few days, but as of right now, there is no indication, other than speculation, that the Fed is going to raise rates. We’ll keep an eye on volatility as the FOMC meeting approaches.

We’ll also look at how you can trade the announcement and the daily effective rate with TRAIDE in the next article!