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20 April 2021
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19 June 2021
Surely there must have been times in your trading life when you wondered what decision the Federal Reserve would make on interest rates at its next meeting. There is a tool that not everyone is familiar with, that allows you to calculate the probability of the Fed raising or cutting interest rates: the FedWatch.
FedWatch is a tool that acts as a barometer for market participants to gauge the market's expectation of potential changes to the fed funds target rate while assessing potential Fed movements around FOMC meetings. The FedWatch is based on the 30-Day Fed Funds futures (Ticker: ZQ).
30-Day Fed Funds futures is one of the most widely used tools for hedging short-term interest rate risk. Fed Fund futures is a direct reflection of collective marketplace insight regarding the future course of the Federal Reserve's monetary policy.
How FedWatch works. First of all, there are some Fed Watch Tool’s Assumption and Interpretations:
- The probability of a rate hike is calculated by adding the probabilities of all target rate levels above the current target rate.
- Probabilities of possible Fed Funds target rates are based on Fed Fund futures contract prices assuming that the rate hike is 0.25% (25 basis points) and that the Fed Funds Effective Rate (FFER) will react by a like amount.
- FOMC meetings probabilities are determined from the corresponding CME Group Fed Fund futures contracts.
The FedWatch tool calculates unconditional probabilities of FOMC meeting outcomes to generate a binary probability tree. CME Group lists 30-Day Federal Funds Futures futures, prices of which incorporate market expectations of average daily Federal Funds Effective Rate (FFER) levels during futures contract months. (E.g., the market price of FFK1 reflects the market consensus expectation of the average FFER level during the month of May 2021.)
The FFER is published by the Federal Reserve Bank of New York each day and is calculated as a transaction-volume weighted average of the previous day’s rates on trades arranged by major brokers in the market for overnight unsecured loans between depository institutions.
Below you can see the scheme to calculate the unconditional probability of a change in the target at the current month FOMC meeting (16 June). The primary consideration is whether there is an FOMC meeting in the month immediately before the “meeting” month. If there was no meeting in the month prior, it is categorised as a “Type 2 meeting." Otherwise, it is categorised as a “Type 1 meeting."
I have made a calculation of the probability of a rate hike at the next FOMC meeting (16 June), which I publish below.
June 16, 2021 FOMC – Type #2 (analysis on 27 May)
- FFERJ1 = 99.917 (April price average)
- FFERK1 = 99.924 (May price average)
- N = 30
- M = 15
- FFER(start) = 100 - 99.917 = 0.083
- ImpliedRate = 100 - 99.924 = 0,076
- FFER(end) = 30/15 * [0.076 – (15/30)*0.083] = 2 * [0.076 – 0.0415] = 0.069
- P(Hike) = (FFER.end – FFER.start) / 25 basis points = (0.069 – 0,083) / 0.25 = 6%
- P(NoHike) = 100 - P(Hike) = 100 – 6 = 94%
Therefore, as of 27 May, the probability of the Fed raising interest rates on 16 June is 6%.
Having said that, I would add that you do not need to do all the calculations above. You can access the same information via a tool, which you can find at the following address: https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html.
You have the possibility to see more meetings and compare the current figure with that of a day, a week and a month before.
Surely there must have been times in your trading life when you wondered what decision the Federal Reserve would make on interest rates at its next meeting. There is a tool that not everyone is
I am a macroeconomic and financial analyst with over 30 years’ experience, including two years as a fund manager. I specialise in currencies and commodities, and I am the author of several successful books on trading, macroeconomics, and financial markets.
