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Ever wondered how the financial news calculate the odds of the next rate hike or what it means when you read "the market" is pricing in a 78% chance of a rate hike for the next FOMC meeting?
Then this answer might help you to understand how these odds are calculated and why they are important.
"Rate hikes affect a lot of companies via higher funding costs and higher difficulty of borrowing" Christian Mayer Quant Group
Given the fact that FED is raising rates, it is important for everyone to understand rate hikes and when they happen. This affects a lot of companies via higher funding costs, higher difficulty of borrowing and potential capital inflows due to higher US yields, which drives up the demand for US treasuries. It is possible to calculate the implied rate hike probability that the market expects for the next couple of months and even years. This can be done via the FED funds futures contracts.
Before calculating the implied rate hike probability, it is important to highlight one key characteristic of CME's Fed Funds futures -‐ the interest rate implied by the price is the price of average daily Fed Funds overnight rate for the delivery month, not the Funds rate at the time of settlement. This means if a rate hike happens on March 15, the average daily overnight rate for the March contract will likely be lower than the actual Funds rate on March 31.
This characteristic can be easily worked around by using the April contract. Since there are no FOMC meetings in April, the April contract's price would reflect the effective funds rate at the end of March.
First of all, you have to get the current effective FED funds rate = 0.66%. This can be found on the Website of the FED (https://apps.newyorkfed.org/markets/autorates/fed%20funds).
Second, you have to calculate the implied yield of the April FED funds futures contract, which is currently trading at 99.145. To get the implied yield you have to subtract 100 -‐ the current future's price (99.145) = 0.855. This is the implied rate for April, according to the market. Now you only have to subtract the current effective FED funds rate of 0.66% = 0.195 and divide this by 0.25 because the FED funds assume a 25 basis points rise in rates for every hike, which equals 0.78. Therefore, the markets are pricing in a probability of 78% for the March FOMC meeting in 2017!
In the chart below you can see how the price change of the April FED funds future helps to visualise the changes implied by the market of a potential rate hike (Here: 72% chance of rate hike in March).
Hopefully you found this helpful. How probable do you think the March rate hike is? Share your thoughts in the comments.