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Predictions about the Federal Reserve’s plans for its Federal Funds rates are not hard to find. Turn on any form of financial news and there’s no shortage of prognosticators discussing where the Fed will take rates.

But there’s another widely cited gauge increasingly used by traders to get a read on the next move for rates. FedWatch, a tool from CME Group, has become a favorite indicator to assess where overnight rates will go as the Fed works to tackle stubborn inflation.

The tool has been around for roughly a decade when CME Group introduced it to make futures prices more accessible and transparent for market participants. 

“FedWatch was created in the spirit of providing efficient tools to help our clients manage interest rate risks in a transparent and cost-efficient way,” said Agha Mirza, Global Head of Rates & OTC Products at CME Group, adding that he and his team launched the indicator after clients showed an appetite for it. 

Surging Interest

Relying on 30-day Fed Funds’ futures prices, the tool uses this data to display both current and historical probabilities of various FOMC rate outcomes for a specific meeting date. Probabilities are based on Fed Funds futures contract prices, assuming that hikes/cuts are sized in 25bps increments. The FedWatch tool also shows the Fed’s “Dot Plot” targeting FOMC members’ expectations for benchmark rates over time. 

Fed Funds futures volumes have soared in 2023. Through May, an average of 550,000 contracts traded daily, up from 333,000 in 2022. Daily futures volume soared to 2.6 million contracts around the date Silicon Valley bank went bankrupt, the highest on record, adding to eight days where it has exceeded 1 million contracts in 2023.

FedWatch isn’t just for traders. Media mentions for FedWatch have also surged. In the second quarter of 2023, mentions were up 308% from 2022 as top financial media from Bloomberg to CNBC to MarketWatch cited the tool as the preferred gauge to help investors predict the future of U.S monetary policy.

Prediction Pathway

“The tool assumes that overnight rates are on average constant between FOMC meeting dates and that rate moves are in multiples of 25 basis points, it then creates a pathway of predicted overnight Fed Funds rates,” Mark Rogerson, EMEA Head of Interest Rate Products at CME Group, explained. “That pathway is used to calculate probabilities of what will occur around FOMC meeting dates.”

The gauge expresses the totality of what most Fed Funds traders expect will happen during FOMC meetings so it’s therefore seen as an accurate and unbiased barometer of where prices will head. 

FedWatch has proven a useful tool for when expectations move suddenly based on news of the day. For example, the tool estimated a much higher probability of a 0.5% hike than a 0.25% hike immediately following Congressional testimony from Fed Chair Jerome Powell on March 7. Following the Silicon Valley Bank failure and intervention from the FDIC and Federal Reserve days later, expectations for the March 22 FOMC meeting moved strongly back to the 25-bps expectation.

Currently, FedWatch is showing a higher chance that the FOMC will start cutting rates in September. Likely drivers of this are banking industry turmoil and easing inflation, which could lower the need for further hikes. The Fed Funds rate puts a price on money by determining what banks charge to borrow from each other, affecting a plethora of consumer and business loans.

Treasury futures volatility is another measure traders can watch as rate expectations change. CME Group also offers the CVOL volatility indexes that track volatility across 2-, 5-, 10- and 30-year treasuries.

Making it Work

Underscoring its broad usage, Alexander Yokum, regional bank analyst at CFRA, said the FedWatch tool has become an essential gauge to help him predict banks’ future growth, as set by their loan portfolio’s health and the future performance of credit markets, among other things. 

He is closely watching it to see where overnight rates will head in coming months as their level will impact how certain institutions in the U.S. banking sector will perform.

“Everything depends on the Fed Funds rate as loans are tied to it,” Yokum confirmed. “That is where bond-term duration, liquidity risks and deposit costs come into play. If rates stay the same, banks will have greater funding pressures but if they fall, they could help alleviate some of the deposit flights we have seen in the industry” as their asset values will improve and liquidity constraints lessen.

Yokum also uses the FedWatch tool to assess potential bank defaults should credit markets deteriorate.

“Higher rates make loans harder to pay which means more potential defaults” affecting lenders’ credit quality portfolio. 

Mortgages are a case in point. “There is much less demand for mortgages right now. Banks make money by refinancing and very few people want to refinance as they would have to pay more for a new loan.”

‘Virtuous Cycle’

Analysts are also watching rates to assess the likelihood of future M&A deals. Currently, this can be crucial when/if trying to determine if regional banks can eventually join forces to survive the crisis.  

“A lot of M&A is done through debt which becomes more expensive with higher rates,” added Yokum. “Activity has understandably come down significantly but if rates begin falling I would expect an uptick.”

Regardless of where rates go, analysts expect the FedWatch tool will remain on participants’ radar screens as they strive to predict the future of the U.S. economy and the range of assets that depend on its performance. 

“The tool offers greater transparency of what future prices mean in the real world,” Rogerson added. “That is why it has become a great resource for traders, analysts, economists and journalists and has helped increase the number of customers trading our Fed Funds products.”

Speaking about its reliability, one market participant concluded: 

"The tool is reliable because it's based on actual futures contracts. I prefer to follow the money, actual dollars of where people are putting cash to work much more than their words or best guesses of where things will go."



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