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The following guest post is courtesy of Ipek Ozkardeskaya, Senior Market Analyst at FCA regulated broker London Capital Group Holdings plc (LON:LCG).
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The probability of a Federal Reserve (Fed) rate hike has become an important gauge to traders nowadays. Almost every news channel, or finance article refer to this probability.
In this article, we will explain – in a reader-friendly fashion, how these probabilities are computed, what they really mean and how they should be interpreted.
What is the probability of a September Fed rate hike?
The probability of a Fed rate hike in September shrank to 24% on Tuesday September 7th, from above 30% at the start of the same week and recovered to 28% on Friday September 9th. Meanwhile, the probability of a December rate hike fell to 50% from 60% and bounced back to 58% over the same period.
The probabilities, as mentioned above, are named after ‘implied probabilities’ and are extracted from the activity in the US’ sovereign market.
A common way to extract the implied probability is to use the Federal funds (FF) futures market, which offers a good liquidity and a range of contracts for different maturities. Therefore, we could extract the probabilities for different maturities with a good level of precision.
Banks and financial institutions often use the Fed funds future contracts to hedge against the unexpected short-term moves. The price of a FF future contact is simply its discounted price from par (100). The rate implied is therefore 100 minus the contract’s price. The price of a contract for the current month is gradually based on the effective Fed rates, yet the price of a future month’s contract is purely based on expectations.
Therefore, the price of a FF future contract contains the information regarding the aggregated market expectations on future Fed interest rates.
Bridge between the market and the Fed
The rapid change in the Fed’s future interest rate probabilities is hence due to a high volatility in the Federal funds futures market, which is very sensitive to economic data, as well as the FOMC members’ comments.
Per se, the probabilities based on expectations are not founded on any official information. They only reflect how the market interprets the bulk of information available at a particular moment in time. Nevertheless, they provide the Fed with a powerful tool to understand the market sentiment, to measure the level of stress and to avoid bad surprises.
The rising popularity of ‘implied Fed probabilities’ allows the Fed to take the pulse of the market with a good level of precision. In other words, the Fed would be expected to refrain from rising the interest rates in September, if the market prices in 25% probability only.
It is important to keep in mind that a 50% probability does not mean that the chances of a Fed rate hike are fifty-fifty. It rather means that the market is only halfway ready to absorb a change in the interest rates at that given month.
Although there are no set rules, based on our empirical observations, we could seriously start considering the possibility of a Fed rate hike as the implied probability stands above the 80% level, and we could talk about a high probability action when this probability reaches 90-95%.