Econbrowser‘s James Hamilton has announced:
Do current fed funds futures prices signal a belief by market participants that the Fed may begin raising interest rates early next year? My latest research paper suggests not.
The expectations hypothesis of the term structure of interest rates posits that an investor could expect to receive the same return from buying a 6-month T-bill as from rolling over two 3-month T-bills. Although this is an appealing hypothesis, it has been consistently rejected by empirical researchers, including Campbell and Shiller (1991), Evans and Lewis (1994), Bekaert, Hodrick and Marshall (1997), and Cochrane and Piazzesi (2005) among many others. What that literature has shown is that when the 6-month yield is higher than the 3-month, on average you’d do better with it than with rolling over the 3-months. Typically the term structure slopes up, and typically you earn a higher return from longer term securities.
In a new paper coauthored with Hitotsubashi University Professor Tatsuyoshi Okimoto, we show that arbitrage should force the predictable excess returns on bonds of longer maturities to show up as predictable gains from taking the long position in fed funds futures contracts. The average upward slope to the term structure of interest rates should imply an average upward slope to the interest rates associated with fed funds contracts of increasing maturity. One might then want to adjust these futures rates to obtain an unbiased market expectation, as suggested in a recent paper by Piazzesi and Swanson.