We developed a tool to help clients visualize the potential impacts of the Federal Open Markets Committee (FOMC) decisions on the expected prices of SOFR futures. By allowing users to input their own expectations of what the Fed might do in upcoming FOMC meetings, this tool provides a view of where our SOFR futures prices could settle if the user’s expectations prevail.
To comprehend how the tool transforms FOMC expectations into potential settlement prices for SOFR futures contracts, you must first understand the benchmark rates involved in these calculations, as well as a few assumptions the tool makes.
The FOMC is responsible for setting the benchmark policy rates for the U.S., and it does so during a number of meetings that take place throughout the year. At each of these meetings, the FOMC decides whether to maintain, hike or cut a range of policy rates. Typically, these moves take place in 25 basis point (bp) increments (0.25%) and the resulting range is expressed as two rates separated by 25 basis points (e.g., 5.00% - 5.25%).
Another factor to consider is the high correlation between these Fed policy rates and overnight SOFR (O/N SOFR). Both of these rates tend to move together, with hikes and cuts being matched in the O/N SOFR rate as soon as the next business day following a FOMC decision. Despite being well correlated, there remains a slight basis (or spread) between the Fed’s policy rate range, and where O/N SOFR prints every morning.
One key assumption that this tool makes is that the basis (or spread) between the lower end of the Fed’s policy rate range and the O/N SOFR is held constant for the purpose of calculating projected forward O/N SOFR rates. That is, the tool observes the basis between the current policy rate range and the effective federal funds rate (EFFR) alongside the forward-looking market-implied basis between the EFFR and O/N SOFR. This aggregated spread between the Fed’s policy rate range and O/N SOFR is established as a fixed constant, which is then used to estimate potential future O/N SOFR fixings.
Once a projected O/N SOFR benchmark curve has been established, you can aggregate the relevant rates to calculate what the projected final settlement prices of any One-Month SOFR (SR1) or Three-Month SOFR (SR3) futures contract might be.
Read our whitepaper for more information about the methodology used to calculate the final settlement of SOFR futures contracts.
How the tool works
SOFRWatch has a couple sources of data: benchmark rate and FOMC data is acquired via the Fed, while SOFR futures reference period dates are supplied through our internal systems.
The first thing the tool does is establish a fixed spread between the O/N SOFR and the lower boundary of the Fed’s policy rate range. This is done in two stages: 1) the tool observes the latest spread between the lower boundary of the Fed’s policy rate range and the Effective Federal Funds Rate (EFFR); 2) the tool adds to this value the average spread between EFFR and O/N SOFR for the upcoming three calendar months, as observed by the prices of our One-Month SOFR futures versus Fed Funds futures spreads (SR1-ZQ). This final calculated spread represents the market’s expectations for how far above the Fed’s target policy rate range the O/N SOFR benchmark will be in the near future. This value is saved for use in all subsequent calculations.
The tool presents users with all scheduled and expected FOMC meeting dates alongside the pre-populated most probable policy action the FOMC might take at each meeting, as informed by FedWatch. The user is given the option to override the projected change with their own expectations of policy change at each of these upcoming meetings by typing in the size and direction of the change (e.g., -25 for a 25bp cut and +25 for a 25bp hike). Although the FOMC typically moves in multiples of 25bp, the tool permits inputs of any size, such as +60 for a 60bp hike, for example.
Finally, given the user’s FOMC expectations, the established spread between O/N SOFR and the Fed’s target rate range, and the past O/N SOFR fixings, the tool can imply where SOFR futures prices might settle.
For each upcoming date, the tool looks at the lower boundary of the Fed’s target rate range and applies any user-inputted cuts or hikes that would have taken place by that date, as well as the established fixed spread between the Fed’s rates and O/N SOFR. The resulting figure is saved as the implied O/N SOFR fixing for that date.
For example, if the current FOMC policy range is 5.00% - 5.25%, the spread between the lower-end of that range and the latest EFFR is 14bp, the average market-implied spread between EFFR and SOFR is 2bp, and the user has inputted his expectations for a 25bp hike in the upcoming FOMC meeting, then the tool would imply an O/N SOFR fixing for the dates after the upcoming FOMC decision equal to: 5.00% + 0.14% + 0.02% + 0.25% = 5.41%. This would be the implied O/N SOFR rate for all days until the subsequent user-defined change in FOMC policy.
Repeating this for all relevant dates into the future (i.e., all dates which would impact a currently listed SOFR futures contract), the tool creates a continuously compounded SOFR value for each day, compounding the daily O/N SOFR fixings from the first relevant contract date until the last implied future O/N SOFR fixing calculated. This allows the tool to price any Three-Month SOFR (SR3) futures contract by simply dividing the continuously compounded SOFR value for the last day in the contract’s reference period by the value for the first day in the period.
Effectively, this process derives the implied three-month compounded SOFR rate, which is used to calculate the final settlement price for Three-Month SOFR futures contracts.
Similarly, the tool also calculates the average O/N SOFR rate for each month. We then use these figures to output the implied final settlement prices for the One-Month SOFR (SR1) futures contracts, given the same user-defined expectations of FOMC decisions.
In the case of either a SR1 or SR3 contract whose reference period has already begun, the tool uses a mix of actual and implied O/N SOFR fixings to calculate a potential final settlement price.
Outputs
Having performed all of the calculations described above, the tool displays the following outputs:
- Two tables, one each for SR1 and SR3, displaying the current prices and implied final settlement prices for each contract expiry, as well as the difference between both.
- A chart of past and implied future overnight SOFR fixings.
- A chart of the current and implied term structures for Three-Month SOFR futures contracts, as well as the difference between both for each of the contract expiries.
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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.