FEDERAL FUNDS TARGET RATE (FFTR)
All About Intra day Trading in the Overnight Fed
Funds Market& Setting of the Fed Funds Target
Transaction-level economic and financial related data for the federal funds market
provide a unique view of the intra-day trade volume and price action.
The actions of the Fed and the Federal Funds rate has a high impact on futures trading, including
30-year Treasury Bond trading and trading in the
Forex spot market and related commodity futures markets.
Click-here to Learn how to trade forex in 90 seconds!
Technical analysis of the price data reveals large move swings in trade volume over the course of
the traders day while prices remain fairly stable, with rate volatility rising
sharply only in the late afternoon. The analysis underscores the important
role played by institutional deadlines—most notably, the close of
trading—in driving movements in this market.
The federal funds market is a key component of the US financial system.
In this market, depository institutions borrow and lend the balances,
or reserves, that they hold in accounts at the Federal Reserve. Through
open-market trade operations, the Federal Reserve’s Trading Desk keeps
the rate of interest charged on these inter bank loans—the federal
funds rate—near a target set by the Federal Open Market Committee.
Market expectations for the "fed funds target rate" play a central
role in monetary policy and are primary determinants of almost all other
US dollar based interest rates.
A significant body of research has emerged in recent decades
on the actions of the federal funds market and its relationship to monetary
policy. Because of data limitations, however, analysts have had to focus
on the day-today behavior of the fed-funds market, often treating the market as
if it cleared at one single instant and at one fed funds rate each day. As a result,
issues important for financial analysis—such as the behavior of
prices and trading activity during each business day, and the role of
the institutional framework in shaping such behavior at different times
of the day—have remained largely unexplored.
In this edition of Current Issues, we use a new set of transaction-by-transaction
data to derive information on the intra day life of the federal funds market.
Emerging from our analysis is a picture of a smoothly operating market
in which large swings in trading activity during each business day tend
to leave the price side of the market fairly undisturbed, with overnight
interest rates displaying stable behavior until the end of the trading
day nears. At that point, rate volatility rises sharply in tandem with
trade volume—evidence, we suggest, of the substantial role played
by trading closures in determining activity in this market.
We begin with a brief overview of the institutional arrangements of the
"fed funds target rate" market that are key to understanding results.
We then describe intra day trading, also known as
day trading, and interest rate
behavior, offering—when appropriate— tentative explanations for
the trading patterns observed.
The Federal Funds Market Defined
The federal funds market is commonly defined as a venue for U.S. depository
institutions (banks) to borrow reserve balances directly from other banks
on an un-collateralized basis, generally for same-day delivery and for
very short terms. A more accurate definition of this market, however,
would reflect the distinction the Federal Reserve makes between various
types of bank borrowings, some of which qualify as federal funds, and
some of which do not.
The Federal Reserve’s Regulation-D requires
banks operating in the United States to hold reserves, either in the form of
balances in deposit accounts at the Federal Reserve Bank or as cash in their
vaults, in fixed proportion to some of their deposit liabilities. Reserve requirements
represent a cost to banks because reserve holdings yield no interest.
But Reg-D exempts from the definition of a “deposit,”
and hence from reserve requirements, bank liabilities arising from borrowings
from other banks, from various government agencies and, under certain
conditions, from securities dealers. These exemptions from Regulation
D effectively make the federal funds market a distinct market in which
trades giving rise to exempt bank liabilities are arranged.
The federal funds market is divided into two segments— brokered
and direct trading—that differ markedly in trading methods, price
dynamics, and institutional participation. In the market’s brokered
segment, trades are initially matched through a handful of brokers, and
participation is mostly confined to larger banking institutions that are
active in other financial markets,
or that settle large volumes of financial transactions on behalf of depositors.
By contrast, in the market’s direct trading segment, trades are
arranged directly between institutions, one of which is often a smaller,
more retail-oriented institution while the other tends to be a larger
institution, active in the brokered segment. Of the thousands of banks
eligible to trade in the federal funds market, only about two or three
hundred are active in the brokered segment. Rates in the brokered segment
are especially responsive to shifting conditions in the aggregate supply
or demand for reserves, while rates in the direct market are often determined
with reference to prevailing brokered rates.
Other key distinctions among federal funds trades are those between overnight
and term loans, and between fed fund trades that settle on a same-day (spot) basis
and those that settle on a forward basis. Spot trades of overnight loans
account for the vast majority of trading. Accordingly, our analysis focuses
solely on spot overnight trading in the brokered segment of the federal
Uses of the Federal Funds Market
Trading in the federal funds market serves two broad purposes. First,
a bank may borrow or lend federal funds to alter its interest rate exposure,
either to take advantage of an interest rate outlook or to guard against
a particular interest rate risk. Used in this way, federal funds borrowed
or lent are similar to many other assets or liabilities on bank balance
sheets except for their unsecured nature and generally short maturity.
Second, a bank may use the funds market to offset other transactions—whether
initiated by its depositors or by the bank itself—that would otherwise
leave it with a reserve position out of compliance with Federal Reserve
Many of the intraday patterns in the
federal funds market . . .
related to institutional features of the Fedwire payment infrastructure.
Banks pay penalties if they end any day overdrawn on their account at
the Fed or if they hold an insufficient cumulative level of reserves at
the end of each two-week interval, or “reserve maintenance period.”
However, because they earn no interest on reserve holdings, banks also
try to minimize the amount of reserves held in excess of their requirements.
When used to maintain compliance with Federal Reserve regulations, the
fed funds market may be viewed as an extension of the wholesale payments framework.
To settle large financial payments undertaken either at their own initiative
(including lending of federal funds) or on behalf of depositors, the banks
making payments instruct the Fed over its electronic payment system —
known as Fed wire — to transfer reserve balances from their accounts
to the accounts of the banks receiving payments. Fedwire instructions
are processed as soon as they are received.
Because of the large, often uncertain flow of payments clearing on Fed wire
every day, banks rely extensively on federal funds trading to maintain
their reserve balances within desirable ranges. It is not surprising,
then, that many of the intraday patterns in the federal funds market described
in this article can be related to institutional features of the Fedwire
payment infrastructure. The most important of these features, as we shall
see, is the closing of Fedwire, scheduled for 18:30, at which point trading
in the funds market for same-day settlement also ends.
Federal Funds Micro Data
To study the intraday behavior of the funds market, we acquired records
of all federal funds transactions executed by
euro trading Euro Brokers (a large broker in this market) for a 2-1/2 year period.
For each transaction we obtained information on the amount traded, the
agreed-upon interest rate, starting date, term, and trade completion time.
(We obtained no information on trading parties.) After dropping forward
and term transactions and a few anomalous data, we were left with a sample
of more than 100,000 individual trades over 660 business days. We arranged
these trades by completion time into twenty-two half-hour intervals beginning
at 7:30, when an appreciable volume of trading in this market begins,
and ending at 18:30, when trading normally ceases. We used data aggregated
over these half-hour intervals as the basic inputs for our analysis.
Intraday Patterns in Trading Activity
Measures of trading activity exhibit large swings over a typical
business day. Trading volume first peaks in the morning, between 8:30
and 10:00, dips from late morning through mid-afternoon, and then peaks
again at even higher levels late in the afternoon, with nearly 40 percent
of total trading condensed in the last two hours. Several factors likely
contribute to this pattern. The morning peak in activity may stem from
efforts by banks with more predictable payment flows and trading needs
to get much of this trading out of the way early on, thereby preserving
maximum flexibility to respond later in the day to trading needs brought
on by unexpected payment flows. The temporary overlap with trading in
European financial centers, when institutions based in these areas are
more active, also likely contributes to a higher volume of federal funds
trading during the morning hours.
The late afternoon rise in activity coincides with a clustering of several
institutional deadlines late in the day. Settlement of securities transactions
ends at 15:00, causing securities dealers to defer much of their trading
in the money market until that time, when their security-related balance
sheet position becomes certain. Banks’ trading of federal funds
late in the day may also be spurred by diminishing uncertainty about client
transactions and other payment flows in the hour or two before Fedwire
closes at 18:30. By postponing trading until such transactions have largely
been completed, banks subject to uncertain cash flows can avoid transaction
and other costs associated with being both a lender and a borrower of
funds on the same day.
Trading volume may be broken down further into trading intensity and
average trade size. The distribution of the total number of trades across
half-hour intervals in each day similar to the distribution of total trading
volume. Average trade size, however, presents a somewhat different pattern,
peaking shortly before security markets close at 15:00 and again just
before the funds market closes at 18:30.
The smaller average trade sizes observed in the morning likely reflect
more active participation by smaller institutions, which face less uncertainty
about payment flows and prefer to avoid the rate volatility prevailing
later in the day. The mid-afternoon peak in trade size may reflect a relatively
greater contribution from large banks involved in clearing security-related
flows, while the late-day peak can probably be tied to heavier activity
by large money-center banks, which are subject to the greatest uncertainty
about their payment flows. Furthermore, as the deadline for trading approaches,
banks often arrange trades in larger blocks to ensure that all needed
trading is completed quickly before the market closes, even if this requires
sacrificing some potential rate advantage.
The smooth decline in average funds rates . . . over a typical business day . . .
likely reflects the different risks faced by
net borrowers and net lenders
in choosing the best time to complete their trading.
Intraday Behavior of the Federal Funds Target Rate
While trading activity fluctuates markedly over the course of the day,
the price side of the market displays more uniform and purposeful patterns,
many of which can be related to the approaching end-day deadline at 18:30.
One such pattern is the smooth decline in average funds rates —
measured as the average deviation from the federal funds target in each
half-hour interval—over a typical business day. This pattern likely
reflects the different risks faced by net borrowers and net lenders in
choosing the best time to complete their trading. In particular, banks
seeking to lend out their excess reserves often have the flexibility to
defer lending from the present day until later in the reserve maintenance
period without risking accumulating too many reserves for the maintenance
For this reason, reserve-rich banks tend to play a more subdued
role in the determination of interest rates around the close of business.
In contrast, banks that keep relatively low reserve balances and must
borrow to meet their reserve requirements are often in the position of
having to borrow some reserves before close of business every day, to
avoid ending any day overdrawn on their account at the Fed. Because of
this risk, these banks may defer their borrowing from early until late
in the day only if slightly lower expected borrowing costs compensate
for the risk that they might not be able to find a lender before the market
Intra-day patterns in fed funds rate volatility also illustrate
how participants in this market respond to liquidity changes with the
aim of minimizing the cost of holding reserve balances while meeting reserve
requirements. Our data show that interest rate volatility remains stable
until mid-afternoon, after which time it rises sharply until day’s
end. Clearly, rate volatility may be higher late in the day because mismatches
between the trading needs of borrowers and
featured lenders are often realized only at that particular time.
For instance, mismatches may occur if banks with available
funds to lend have exhausted (or never had) a lending line of credit to
banks needing to borrow. More widespread disparities may also arise if
the supply of reserves left by the Fed’s Trading Desk after arranging
open market operations in the morning does not match banks’ aggregate
demand for reserves. These imbalances are generally not recognized until
rather late in the day, thus increasing the potential for abrupt interest
rate movements at that time.
There is, however, a more subtle reason for the intraday rise in volatility.
Over the course of each trading day, banks are subject to recurrent shocks to
their holdings of reserves when they make or receive payments on behalf
of their depositors or when they settle the trades they have arranged
in other markets. Initially, these shocks poorly predict banks’
net need for reserves during the rest of the day, since many other, possibly
offsetting shocks may occur before day’s end.
As a result, banks need not enter the funds market to respond fully or immediately to payment
surprises coming early in the day, and so these shocks tend to have little
impact on rates. However, as the day advances and payment shocks begin
to signal more clearly banks’ net borrowing or lending needs during
the time remaining before market close, banks respond more promptly to
Relationship between Intraday Trading Volume and Rate Volatility
To what extent does rate volatility in the federal funds market move with
trading volume over the course of the traders day? A comparison of
free commodity charts reveal
a clear correlation late in the trading day, just ahead of the close of the
market, when both trading volume and rate volatility surge. Earlier in
the trade day, however, no such correlation is evident: trading volume starts
out high in the morning and then falls steadily until midday, while rate
volatility is relatively stable thru out these hours.
This pattern contrasts with that observed in equity and other markets,
where trading volume and rate volatility tend to move together throughout
the day. Both volume and rate volatility start from high values at market
opening, decline until mid-day, and then—as in the federal funds
market—increase steadily ahead of market closing.
One explanation often advanced for the positive link between trading
volume and rate volatility in equity and other markets centers on the
role of trading closures. According to this explanation, news accumulated
during the over-night non-trading period causes trading volume...
The surge in trading volume and rate volatility in the fed-funds market toward the end
trading session is consistent
with the explanation that market closures contribute
to the positive link between trading volume and rate volatility.
and rate volatility to spike up at market opening as investors adjust
the trade positions inherited from the previous day to reflect overnight news.
Similarly, as the end of the trading day nears, investors increase trading
in preparation for the overnight closure, and interest-rate volatility rises.
The surge in trading volume and rate volatility in the federal funds
market toward the end of the trading session is consistent with the explanation
that market closures contribute significantly to the positive link between
trading volume and rate volatility. And the absence of any similar positive
correlation between trading volume and rate volatility early in the morning
may be attributed to the existence of a closely related market, the
24-hour forex trading markets,
which are always open before the federal funds market is active, affording
many institutions the opportunity to adjust to overnight news well before
the opening of the funds market.
Volume and Rate Patterns on High-Payment-Flow Days
Finally, we explore the behavior of the federal funds market on days with
a high concentration of securities settlements, government payments, and
other systematic shocks to payment flows in the financial system. We find
that the intraday deviation of rates from the target shifts up sharply
on high-payment-flow days, by about 7 basis points on average.
Despite this upward shift, however, the contour of rate movements over
high payment flow days is qualitatively similar to what's observed on other
days. Similarly, we find no significant difference between high-payment-flow
and other trading days with respect to average daily trading volume, its
intraday distribution, or intra-day rate volatility. We interpret these market
patterns as suggesting higher payment flows serve to increase banks’
precautionary demand for liquid funds without altering banks’ response to
shocks or their incentives to trade at particular times of the day.
Conclusion Lying at the heart of the US financial
structure, the federal funds market accommodates the trading needs of
banking institutions that must borrow or lend reserves on short notice
and for short periods. The market’s daily life is characterized
by a number of institutional deadlines, the most important of which is
the cessation of reserve flows between banks on Fedwire at day’s
end. The final tallying of banks’ reserves for regulatory purposes,
also occurring at the closing of Fedwire, provides further incentive for
banks to trade near the end of the day. Our analysis shows both trading
activity and dollar bill exchange rates
display their most pronounced movements in conjunction with this deadline,
although distinctive market interest rate patterns are also exhibited during
the rest of a typical business trading day.
The intra-day patters we document warrant closer scrutiny. In principle,
they are likely to be more robust over time than those bi-weekly patterns
associated with different days in a reserve maintenance period that have
been the focus of previous studies. For while the Federal Reserve’s
Trading Desk may influence day-to-day rate patterns by adjusting its provision
of reserve supply within a maintenance period, under its current operating
framework, it lacks a good means to alter intra-day interest rate prices.
Click-here to see article,
charts, footnotes and information about authors (.pdf format).