CME FedWatch Tool is a Prime Hedging Mechanism against U.S. Prime Rate Ambiguity

Mar 08, 2023
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After yesterday’s Powell’s testimony before the congressmen in the House of Representatives, market expectations quickly shifted course: by midday, CME FedWatch Tool showed a 67.5% probability of a half-point hike at the March 21-22 meeting. According to the CME FedWatch Tool, the probability of a quarter-point hike was more than 96% in the days that followed, despite all recent weeks market sentiment was largely based on the common perception that the pace of rate hikes will be slowing down.

Using the information based on the U.S. federal funds rate, CME Group created the CME FedWatch Tool to act as a barometer for the market’s expectation of potential changes to the fed funds target rate while assessing potential Fed movements around FOMC meetings (https://www.cmegroup.com/education/courses/understanding-stir-futures/introduction-to-cme-fed-watch.html).

The federal funds rate is one of the most influential interest rates in the United States. Market participants turned to the 30-day fed funds futures contract to hedge against potential changes in short-term interest rates, or to express their views. These contracts are listed on a monthly basis and are priced at 100 minus the expected policy rate.

The Fed, indeed, made the case in February by enacting a quarter-point interest rate hike for the first time in a long while — the slowest increase after months of jumbo-sized rates — it was all but certain that the moderated pace would repeat at the central bank's next meeting.

But in the days and weeks that followed, critical economic data came in scorching hot, from the labor market to consumer spending to some inflation metrics.

In his testimony yesterday, Powell surprisingly said the Fed is prepared to increase the pace of its rate hikes if that continues.

“The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated,” Powell told lawmakers. “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”

This certainly makes the difference.