The CME Group developed the CME FedWatch Tool using this data based on the federal funds rate to operate as a barometer for the market’s anticipation of future changes to the fed funds target rate and to analyze probable Fed moves around FOMC meetings.
The Fed Funds Rate is what?
The Federal Open Market Committee, sometimes known as the FOMC, directs the monetary policy of the US Federal Reserve System. This group meets eight times yearly to decide on a target federal funds rate or target range.
One of the most important interest rates in the United States is the Federal Funds Rate. Market investors use 30-day Fed Fund Futures contracts as a hedge against or a way to communicate a position on expected changes in short-term interest rates. These futures are priced at 100 below the anticipated fed funds rate and posted monthly.
For instance, if the contract for the current month is priced at 99 and the market anticipates that the average federal fund’s effective rate for that month would be 1% (they would calculate 100 minus 99).
The FedWatch Tool was created by CME Group using this data. This tool is a barometer for market players to monitor anticipated Fed movements around FOMC meetings and quantify market expectations of potential adjustments to the fed funds target rate.
How to Use the CME FedWatch Tool
Assume the current FOMC target range is 0.75 to 1.0 percent (or 75 to 100 basis points).
We would first choose the tool’s output for the upcoming meeting, which offers two possible results.
The bar on the left shows the likelihood that rates will stay the same. The bar to the right shows the probability that interest rates will rise by a single increment of 25 basis points to a target range of 100 to 125 basis points.
Look at some analysis for a subsequent conference that will take place in six months, which, based on the probability tree’s structure, has a greater number of possible outcomes.
Once more, choose the output for the meeting held in six months.
The chance of rates being unaltered is still represented by the first bar, while the probability of at least one rate rise occurring at or before this meeting is represented by the sum of the remaining bars.
How the CME FedWatch Tool is Affected by FOMC Expectations
The FOMC releases a dot plot four times a year that shows how each committee member believes the monetary policy should be after the following four years. Each of the 17 dots in a particular column represents one member’s forecasts for the federal funds rate’s target level or midpoint.
The CME FedWatch Tool enables market participants to quickly contrast the FOMC’s official forecasts with those reflected in the futures market. The light blue dots indicate the members’ median prediction, while the red dots indicate the effective rate suggested by the year-end Fed Fund futures price.
The Assumption and Interpretations of the FedWatch Tool:
- Adding the probabilities of all goal rate levels above the present target rate yields the possibility of a rate increase.
- Fed Funds futures contract prices are used to calculate the likelihood that the Fed Funds Effective Rate (FFER) will increase by 0.25 percent (25 basis points), based on the assumption that the rate hike will have the same effect.
- Probabilities for FOMC meetings are calculated using the matching Fed Fund futures contracts from CME Group.
- On a publicly available calendar, FOMC meetings take place with a broadly even distribution, with one meeting not taking place every three months.
- Each period’s estimated end rate for FFER should be equal to the period’s planned start rate for FFER.
- Calculated probabilities are estimates based on these hypotheses and may change if one or more are broken.
The FedWatch program analyzes the unconditional probabilities of Federal Open Market Committee (FOMC) meeting outcomes to create a binary probability tree. CME Group offers the 30-Day Federal Funds Futures (FF) futures, and their values reflect what the market anticipates will be the average daily Federal Funds Effective Rate (FFER) levels for the months of the futures contract. (For instance, the market price of FFU5 represents the market’s consensus view for the average FFER level expected in September 2015). The FFER, computed as a transaction-volume weighted average of the rates on deals handled by prominent brokers in the market for overnight unsecured loans between depository institutions, is released by the Federal Reserve Bank of New York every day.
The implementation of the FedWatch tool’s probability analysis assumes that the size of a rate change is always 25 basis points and that, for a given month of the FOMC meeting, the prices of prior or post-FF futures contracts contain information that is either independent of or solely dependent on the outcome of that meeting. The FedWatch tool also assumes that FFER is constrained by zero below. If one were in a month with an FOMC meeting but no FOMC meeting in the prior month, then the FF futures price of the prior month contains information separate from the current month’s meeting. This is because the price of each FF futures contract represents the expected average daily FFER for the contract month. The FF futures price of the following only provides information about the results of the current month’s meeting if you were in an FOMC meeting month and there was no FOMC meeting planned for the next month. The odds of a rate hike vs. no rate hike would be estimated as follows if one considers that the FOMC would vote to either increase its daily FFER goal or maintain the status quo at its meeting this month:
P(Hike) is equal to [FFER(month’s end) – FFER(month’s beginning)] 50 basis points
P(NoHike) equals 1 – P (Hike)
Because implied probabilities are calculated based on a comparison of FFER (end of the month) vs. FFER, whether the FOMC sets its aim for daily FFER as a level or as a range shouldn’t have an impact on the price of FF futures or the calculation of the implied probability of FOMC meeting outcomes (start of the month). The likelihood of a rate change is relative to the predicted End-of-month goal against the expected Start-of-month target, provided that changes in the FOMC target levels are of the size of 25 basis points (whether as the change in a specific target level or the position of a target range).