Reading Interest-Rate Tea Leaves
Interest rates are on the rise. But how far will they go? In this installment of Market Measures, a series on analytical tools that can help sharpen your investing skills, we'll look for the answer in the financial futures market. That's where banks, corporations, and institutions often go to lock in the rates they'll pay for borrowings that they may not make for months or several years. Collectively, the prices that arise from their trading become today's market forecast of rates.
True, these forecasts don't always turn out to be prescient. But Anthony Crescenzi, bond market strategist at New York brokerage Miller Tabak, says they provide useful intelligence. "Knowing the market's expectations is the start of any investing decision," says Crescenzi, author of The Strategic Bond Investor (McGraw-Hill (MHP ), $29.95).
To get a fix on future rates, Crescenzi suggests looking at futures contracts on Eurodollars -- more specifically, dollar-denominated certificates of deposits that trade in London -- because the contracts are by far the most actively traded interest-rate product.
You'll find Eurodollar futures prices in newspapers' futures tables or at the Chicago Mercantile Exchange's site, www.cme.com. Each Eurodollar futures contract represents an interest rate on a three-month deposit of $1 million. The December, 2003, contract, for instance, recently traded at 98.855. Subtract that from 100, and the difference, 1.145, is the "implied" interest rate -- 1.145%. For the December, 2004, contract, the implied rate is 2.35%. That's useful information if you are, say, taking out an adjustable-rate mortgage or home-equity loan, or are wondering when there'll be higher rates on CDs.
Even though the Eurodollar's interest rate is pegged to the London Interbank Offer Rate, or LIBOR, Crescenzi says it's a good proxy for the federal funds rate -- what U.S. banks charge one another on loans. To get an approximate fed funds rate on contracts expiring in 2004 and beyond, Crescenzi subtracts 0.25 of a per- centage point from the Eurodollar rate.
With the bond market shifting gears, checking these futures prices from time to time will help you to keep tabs on changing sentiments.
By Susan Scherreik