Understand the market consensus of Fed Rate

The 'interest rate' plays a crucial role in the equity market, including stock options. It is not an exaggeration to say that the interest rate has the strongest market-wide impact. To be more precise, the interest rate referred to in this context is the target fed funds rate that the Federal Reserve decides during its FOMC (Federal Open Market Committee) meetings. The FOMC meeting is usually held every six weeks, where members of the Federal Reserve meet to discuss the nation's most important monetary policies.

Market participants constantly monitor and predict the Fed's next move on the interest rate: hold, raise, or cut. Opinions will vary. The best way to gauge market consensus is to observe the short-end yield curve. A yield curve is constructed using the market prices of heavily traded financial instruments, including so-called fed funds futures, whose prices are heavily influenced by traders' expectations of the future fed funds rate. Hence, the current market price of these instruments represents the consensus of all market participants.

Professional traders require a very finely tuned yield curve to assist their trading. For retail traders, the CME Group publishes a summary table that is sufficiently accurate. At the time of writing, this table can be found by searching for 'CME FedWatch Tool'. A sample snapshot is shown below.


The left-most column shows the upcoming FOMC meeting dates. The first row indicates the expected fed funds rate. At the beginning of the year $2024$, it is anticipated that the Fed will gradually reduce the rate. Consequently, the current rate ($525-550$) is displayed on the rightmost side, where the numbers are expressed in basis points (bp). One basis point equals $0.01\%$, meaning the current market rate ranges between $5.25\%$ and $5.50\%$.

The body of the table outlines the probability of the target rate range that the Fed decides on at each of its FOMC meetings. For instance, according to this table, there is a $79.9\%$ chance that the target rate will stay within the range of $5.25 - 5.50\%$, indicating no change at the $5/1/2024$ meeting. The first reduction is expected at the June meeting, with a $55.8\%$ probability of a $25$bp cut. Following this logic, the current market consensus suggests there is roughly a one-third chance that the rate will fall into the range of $4.25 - 4.50\%$ by the end of the year, equating to a total of four cuts, each by $25$bp.

These data are inferred from the market price of the currently traded fed funds futures. Therefore, the results represent a probability distribution. Given that different people have varying opinions on the Fed's future actions, it is nearly impossible to be $100\%$ certain about future rates. However, it is feasible to generate a probability distribution based on the consensus, which is precisely what the table illustrates.

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