Professional football games, the weather, and Federal Reserve interest rate policy may seem like wildly divergent subjects, but they all share at least one commonality: People are forever attempting to predict the outcomes of each with varying degrees of success.
Football fans may disagree, but the stakes don't get much higher than Fed policy. In 2024, that was certainly the case as the U.S. central bank grew closer to moving away from a historically aggressive policy-tightening phase toward rate-cutting for the first time in over four years. That shined a particularly bright spotlight on the CME FedWatch Tool and other indicators that aim to place odds on the Fed's rate moves.
How accurate are those odds? One way investors might look at it is to remember that even the best Las Vegas oddsmakers and TV meteorologists don't always get it right. The FedWatch Tool may not be perfect, but it still can be a valuable mechanism offering investors a real-time, market-based window into ever-shifting expectations and sentiment.
"Keeping a close eye on rate expectations through the FedWatch Tool and other indicators can help individual investors prepare and potentially capitalize on rate movements when they happen," said Collin Martin, director of fixed income strategy at the Schwab Center for Financial Research. "If we move into a lower-rate environment, as the Fed has signaled, it's important to get early perspective on how that may impact various asset classes in a portfolio."
Watching such tools may be a good idea for investors, but it may be even more important to understand how they work. We'll focus mainly on FedWatch.
Simple math behind Fed rate expectations
The CME FedWatch Tool is based on prices of 30-Day Federal Funds (/ZQ) futures contracts traded on the CME Group, a Chicago-based exchange. Like futures linked to crude oil, gold, and soybeans, fed funds contracts are bought and sold by professional traders and investors responding to or anticipating economic data, geopolitical developments, and other real-world events.
The FedWatch Tool applies a formula based on daily trading in federal funds futures contracts and spits out percentage-based probabilities on where the benchmark funds rate may be following the conclusion of Federal Open Market Committee (FOMC) meetings held at various points during the year.
To get a sense of traders' rate expectations, subtract the current price of a federal funds futures contract from 100, then tack on a percentage mark to the remainder. That percentage is an approximate estimate of what traders expect for the fed funds rate.
The image below lists the CME Group 30-Day Federal Funds futures used to calculate via the FedWatch Tool. In this example, the price for the May 2024 contract (/ZQK24, yellow arrows) suggested traders expected the fed funds rate to be around 5.315% that month (100 – 94.685 = 5.315). That's right in the middle of the current funds rate target of 5.25% to 5.50%. In other words, traders expected the Fed would hold rates unchanged. The contracts are listed for every month of the year and can be tracked on the MarketWatch tab (yellow rectangle) on the thinkorswim® platform.
Chart source: thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results.
The federal funds futures that provide the basis for the FedWatch Tool offer a snapshot of professional traders' collective expectations of Fed rate moves. If traders expect the Fed to raise rates after an upcoming policy meeting, the price of the federal funds futures contract corresponding with the month of the meeting would be lower than the current funds rate.
In another example, earlier this year, March 2024 30-Day Federal Funds (/ZQH24) futures traded at 94.675, which subtracted from 100 equals 5.325% or roughly in the middle of the Fed's current target range of 5.25% to 5.5%. In other words, traders expected the FOMC, the Fed's policy-setting arm, to hold the rate unchanged following its March 19 – 20 meeting, and that's exactly what happened.
More recently, during early May, buying and selling activity in June 2024 30-Day Federal Funds futures contracts generated FedWatch Tool odds of about 90% that the FOMC will hold rates steady in June.
The fed funds rate itself is one of the most important indicators in the financial markets because it directly or indirectly influences interest rates for almost every type of debt, from mortgages to credit cards to bonds. It is the rate at which banks and depository institutions lend excess reserves to each other overnight, and a committee of Fed officials adjust the funds rate based on inflation data, economic indicators, and other factors. As most Fed watchers know, once Fed officials conclude their policy meetings, one of the first things they do is announce whether they made any changes to the funds rate.
Over time, the FedWatch Tool has assumed greater prominence among many investors. But it has also taken some criticism over not always providing an accurate forecast of what the Fed ultimately has done with rates (which lately is nothing). That in part reflects how the unusual circumstances of recent years have made it so difficult to accurately predict a lot of things about the market and the economy. It's also important to remember that inaccurate forecasts shouldn't be viewed as an indictment of the FedWatch Tool or other indicators, which, after all, are dependent on inputs from the market to generate their forecasts.
In the middle of May 2023, shortly after the regional banking crisis flared, investors had high confidence the Fed wouldn't hike rates in coming months and perhaps might even lower rates by the end of the year. The funds target at that time was 5% to 5.25%. Based on the FedWatch Tool, the market assessed odds the target would be lower by the end of 2023 at greater than 85%.
At the time, many economists predicted the economy was heading for a recession, which typically lowers demand and brings inflation down. Instead, the economy kept rolling and inflation remained elevated. The Fed boosted the funds rate one more time by the end of July.
Predicting a pivot point?
In 2020, the Fed slashed rates to near zero to help prop up the economy as the COVID-19 pandemic escalated. By 2022, the economy had bounced back quicker than expected. That forced the central bank to hike rates sharply to get inflation under control after it had rocketed to four-decade highs.
Even though inflation remains above the Fed's 2% long-term target, many analysts believe the central bank will eventually lower rates. But nobody knows for sure when that may happen. And that's made "What's Jerome Powell thinking?" a more popular parlor game than ever.
How do we know that? Follow the money.
Increased trading illustrates how investors are increasingly willing to put money down based on beliefs the Fed may or may not adjust rates. Trading in the CME Group's 30-day Federal Funds futures contract soared 32% in 2023 from 2022 to an average of nearly 442,000 contracts per day as traders stepped up efforts to speculate on or hedge against potential Fed rate changes. Federal funds futures ranked sixth out of roughly 60 CME Group interest-rate-based products in terms of average daily volume.
In another illustration of heightened trading linked to Fed policy expectations, on April 10, 2024, the day the Bureau of Labor Statistics released its March CPI report that came out hotter than expected, federal funds futures trading soared to over 922,000 contracts, according to CME data. That was more than triple the previous day's trading, as the market responded frantically to the hotter-than-expected inflation numbers and reordered its outlook for rates.
In the image below from the CME Group's website, the FedWatch Tool indicated traders on May 7, 2024, priced more than 91% odds the Fed would hold the funds rate unchanged at 5.25% to 5.5% at its June policy meeting (red circles). Expectations for a quarter-point cut were low, at less than 9% (yellow circle).
Chart source: CME Group. For illustrative purposes only. Past performance does not guarantee future results.
Markets, moving targets, and misfires
Over the past year or so, the FedWatch Tool hasn't exactly hit the mark against post-FOMC meeting reality. As you might expect, the further ahead in time the tool tries to forecast, the less accurate it tends to be. Back in March 2023, for example, federal funds futures suggested the funds target would be lowered to around 4% by the end of the year. Instead, the Fed has held the rate at 5.25% to 5.5% since last July.
The image below shows that during March 2023, the CME Group December 30-Day Federal Funds (/ZQ) futures contract rallied above 96 (red arrow), reflecting escalating expectations the Fed's benchmark funds rate would be much lower by the end of the year (100 – 96 = 4% funds target rate). Instead, markets calmed as the regional banking crisis subsided, and elevated inflation kept the Fed on a rate-hiking path. By the end of 2023, market expectations had adjusted to reflect no change in the funds rate (yellow arrow), which is what happened (100 – 94.67 = 5.33% funds target rate).
Chart source: thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results.
Such misfires may have less to do with any flaws in statistical formulas and models and more to do with how volatile and dynamic today's markets are and how difficult it is to accurately predict the path of economy.
Last summer, after the Fed boosted its funds rate to a 22-year high, many economists seemed certain the economy was headed for a slowdown—possibly even a recession. Instead, the economy kept chugging along, generating a string of robust indicators in late 2023 and early 2024 that prompted traders to sharply rein in aggressive expectations for rate cuts.
With day-to-day shifts in sentiment and expectations aside, investors would be wise to consider the big picture.
As of early May 2024, the Fed appeared to be backing away from previous projections, suggesting it may lower rates about three times this year. Job growth remained surprisingly resilient and inflation perked up, with the Consumer Price Index (CPI) topping expectations each of the first three months of the year.
That's prompted investors to sharply scale back rate cut expectations. During the first week of May, odds of a quarter-point cut in June dropped to about 10% from 62% a month earlier, according to the FedWatch Tool.
Fed cuts and the trickle-down effect
When might the Fed lower rates, and by how much, and how many times? Again, nobody knows for sure. But the informed investor should already have an idea of the implications.
"The timing and magnitude of rate cuts (or hikes) matters for investors in many ways," Schwab's Martin said. "This is especially true if their investments are closely correlated with the fed funds rate, as is the case with money market funds."
Fixed income, short-duration assets likely would see the most immediate effects of Fed cuts.
"If the Fed cuts rates, money market funds will likely see yields decline," Martin explained. "There could also be indirect links with longer-term bonds and with stocks. If cuts come sooner, that could be good for stocks, but not necessarily. If the Fed cuts for 'bad' reasons, such as an economic downturn, that could be bearish for stocks."
Money market fund investors, for example, may not want to get too attached to their current yields, which have topped 5% since last summer, in the wake of the Fed's most recent hike. But as recently as two years ago, before the Fed's rate-hiking binge, money market fund yields were microscopic—less than 0.1%.
If and when the Fed cuts rates, money market yields, as well as those for CDs, short-term Treasury bills, and other shorter-term assets, will usually follow the Fed lower. Under these circumstances, a proactive tack could serve an investor well.
Rather than waiting and risk reinvesting at lower yields, some investors may choose to lock in what are still historically high yields for some intermediate- or long-term bonds, according to Martin. "That way you can know that you'll earn 4% or 4.5%, for example, for a specific period of time, rather than focusing on short-term bonds and being at the mercy of the Fed," he said.
If a recession does eventually come and the Fed needs to cut rates more than expected, a 4.5% yield on the 10-year Treasury note (TNX) might look pretty appealing.
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