FED Rates: Odss Priced

Credit to Monday Morning Macro

For those looking for a more detailed way of thinking about “odds”, a brief practitioners’ guide below. 

First, the September “odds”. The simplistic way to think about the pricing of odds for Fed cuts at upcoming meetings is to look at how many basis points lower that rate is versus the current spot rate. Right now, here’s what those rates look like vs the 1-month “spot” rate.

What’s currently priced into each of the mtgs this year.

In other words, the September FOMC is pricing in a total of 34.5bps, the October meeting is pricing in just over 2 “cuts” between now & then, and the December meeting is priced for just under 3 “cuts”.

What’s crucially important is this: just because the September FOMC has 34.5bps priced in, that doesn’t mean that there’s a 62% chance of a 25bps cut & a 38% chance of a 50bps cut.

If that were true, then that would mean you’d need to think there was 0% chance of the Fed staying on hold (it’s low, to be sure, but nothing’s 0% until it’s realized) *and* more importantly 0% chance of the Fed cutting by any more than 50bps. Clearly, that can’t be the case either. The Fed has routinely cut by more than 50bps in a crisis (the GFC, for example) and they will again. There’s a better way of doing this, and it involves using the options market.

Using current Fed Funds curves & fwd FRA/OIS, we can fit all possible Fed “paths” between now & the end of this year to current mkt pricing of the Eurodollar & OTC swaption mkt. The resulting probability distribution returns a shape of the fwd OIS curve for each meeting.

 

Brian Twomey

 

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