Using this information based on the federal funds rate, CME Group created the CME FedWatch Tool to act as a barometer for the market’s expectation of potential changes to the fed funds target rate while assessing potential Fed movements around FOMC meetings.
What is the Fed Funds Rate?
The Federal Open Market Committee or FOMC is responsible for guiding monetary policy for the United States Federal Reserve System. This committee meets eight times a year to establish a target rate or target range for the federal funds rate.
The Federal Funds Rate is one of the most influential interest rates in the U.S. In order to hedge against or express a view on potential changes in short-term interest rates, market participants turn to 30-day Fed Fund Futures contracts. These contracts are listed monthly and are priced at 100 minus the expected fed funds rate.
For example: If the current month’s contract is priced at 99, and the market expects the average federal funds effective rate during that month to be 1% (they would calculate 100 minus 99).
Using this information, CME Group created the FedWatch Tool. This tool acts as a barometer for market participants to gauge the markets expectation of potential changes to the fed funds target rate while assessing potential Fed movements around FOMC meetings.
How the CME FedWatch Tool Works
Assume the FOMC target range is currently set as 0.75 to 1.0 percent (or 75 to 100 basis points).
First, we would select the tool’s output for the nearest meeting – which has two potential outcomes.
The bar on the left represents the probability that rates are unchanged. The bar on the right shows the probability that rates will be increased by a single, 25 basis point-increment, to a target range of 100 to 125 basis points.
Now, look at some analysis for another meeting that is six months away, which has a higher number of outcomes given the structure of the probability tree.
Again, select the tool’s output for the meeting that is six months away.
The first bar still represents the probability that rates are still unchanged, while the sum of the remaining bars represents the probability of at least one hike at or prior to this meeting.
How FOMC Expectations Affect the CME FedWatch Tool
Four times per year, the FOMC publishes a dot plot which represents a single FOMC member’s assessments of appropriate monetary policy at the end of the next four years. Each of the 17 dots in a given column corresponds to one of the member’s expectations for the midpoint of the target range, or a target level, of the federal funds rate.
The CME FedWatch Tool also offers market participants an easy comparison of the FOMC’s stated projections against those priced into the futures market. The dots marked in light blue represent the median projection among the members while the dots marked in red represent the effective rate implied by the year-end Fed Fund futures price.
The CME FedWatch Tool can be a valuable Instrument for those managing risk or hedging against changes in Fed monetary policy.
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