In a previous post I talked about the fixed income market (interest rates)Â and provided a link to an article I’ve put up on the site which provides an overview of it. In response to reading that article, I received the following question:
“I am getting an education reading your material. I have one two-part question for now. Which maturity(s) are used as a proxy by FI traders who are handicaping the probability of the next Fed rate hike or decline and can you tell me how the probabilities are estimated from the futures interest rate prices each day. For example, Santelli (CNBC market reporter)Â will say that the odds at the moment are about 25% that the Fed will cut rates in March of next year. How does he and others get to that figure?”
This is a very timely question given tomorrow’s interest rate policy announcementÂ (about 2:15 Eastern).Â
When you hear Santelli and the others talk about the probability of a Fed rate move, they are using the Federal Funds futures to make that assessment. The Fed Funds Rate is the one most commonly adjusted by the Federal ReserveÂ when they are adjusting interest rates.
The Fed Funds futures contract trades like any other. Their settlement value is 100 minus the average Fed Funds Rate for the month at the time of settlement which is normally the same as the Fed Funds target rate determined by the Federal Reserve Open Market Committee (FOMC). For example, if Fed Funds is 4.5%, the futures would have a value of 95.50 (100 – 4.5).
Because futures are both freely traded and forward looking, they can be used to get a view on the market’s expectation for the future. If the Fed Funds futures prices for more forward months (further in to the future) are trading significantly higher than for the current or nearby months, that implies the market expects rates to fall (remembering that rising price means lower Fed Funds rate). How much higher those prices are (or lower in the case of rising rates) is an indication of how confident the market is that a rate move is coming.
When you hear on CNBC that there is an X% chance of a rate hike, that simply means the nearby futures are being compared to the ones which mature after the FOMC meeting in question. The difference is used to approximate the probability, as the market sees it, of the move happening. The bigger the difference, the more likely the move – or the bigger the expected move if it’s a question of more than a 25 basis point adjustment.