Quick tutorial of how to use the CME Group’s new “Fed Watch” web tool, which automatically calculates the probabilities of changes to the Fed Funds Target Rate based on the CME Group’s Fed Fund Futures contracts.
Fed Funds Target Rate (FFTR):
“The Fed Funds Target Rate (FFTR) is America’s most important and most influential benchmark interest rate. The FFTR can be described as the “main” or “key” interest rate for the United States. The interest rate-setting Federal Open Market Committee (FOMC) uses the Fed Funds Target Rate as its most potent tool for regulating the U.S. economy, lowering it when the economy needs a boost, and raising it when the rate of inflation is too high.” ~ wsjprimerate.us
Fed Funds Futures Contracts:
“The owner of a fed funds futures contract is obliged to take delivery of the interest paid on a principal amount of $5 million overnight fed funds held for 30 days.
The price of a fed funds futures contract is 100 minus the average fed funds rate during the contract month. For example, during a month when the fed funds rate averaged 5.5%, the fed funds futures contract would settle at 94.50.
The prices of fed funds futures contracts imply expectations for the fed funds rate. For example, suppose the fed funds rate is currently 5.5%, and next month’s fed funds futures contract is trading at 94.46. The price implies an average fed funds rate during the month of 5.54%.
Also suppose that the Fed meets on the 20th of the contract month, a 30-day month. If at its meeting the Fed raises the fed funds rate from 5.5% to 5.75%, the average rate for the month would be 5.58%. Here’s how you figure:
(5.5% * 20 days) + (5.75% * 10 days) / 30 days = (110% + 57.5%) / 30 = 167.50% / 30 = 5.58%
The key point here is that a 25-basis-point rate hike by the Fed would produce an average fed funds rate for the month just 8 basis points higher than the current rate of 5.5%.
So a fed funds futures contract pricing in an average rate of 5.54% for the month is pricing in 4 of the 8 basis points by which the average rate would rise in the event of a 25-basis-point hike. Because 4 / 8 = 50%, we say the contract is pricing in a 50% chance of a rate hike.” ~thestreet.com