Can you please explain how one calculates an x% probability of a rate cut by 50 basis points by looking at the Fed Funds Futures? (February 3, 2001)

  This indicator has received a lot of attention in the past few weeks since the Fed surprised the market with a 50 basis point cut. As we had been reporting in November and December, the FFF contract was not fully pricing in a rate cut at the December 19 FOMC meeting, but after the market tanked subsequent to that meeting, it started to price in a 25 and even 50 basis point move. After that turned out to be the case, everyone started reporting on it. As such, it may lose some of its efficacy as a predictor, but for now its record is clean.

What you have to do is know when the Fed meets and then look at the contracts both before and after that meeting. In that way you can look at the numbers and determine if a rate cut is being priced in before or after the meeting. We will use the recent January 31 FOMC meeting as an example.

As the meeting was at the end of January, the January and February contracts were primarily in play. Why? Because the January contract would tell us if a pre-meeting move was being priced in as it was the near-term contract that would expire at the time of the meeting. The February contract would act as a backup or confirmation of how strong the January contract was by how much of a rate cut it built in. The further out you go on a contract, it should more firmly entrench a rate cut. If the January contract built in 25 basis points, the February might have built in just 25 basis points, or 50 basis points (the actual case). That would mean that by the end of the contract the bet was a 50 basis point cut would come.

In January, the January FFF contract was showing signs of 50, then less than 50, and then 50 basis points before the meeting. The readings go as follows:
94000 would be no chance of a rate cut
94250 = 100% chance of a 25 basis point cut
94375 = 100% chance of a 25 basis point cut, and a 50% chance of a 50 basis point cut.
94500 = 100% chance of a 50 basis point rate cut.

The numbers can range everywhere in between. To calculate the percentage, take the current price. One day it was 94480. It was over 94250, so we knew it was factoring in a 100% chance of a 25 basis point cut. It was less than 94500, so we knew it was less than a 100% chance of a 50 basis point cut. So, we took 94480 - 94250 to get 230. That is the price over and above a 100% chance of a 25 basis point cut. We then divide 230 by 250 (the price of a full 25 more basis points in cuts) and that gives us 0.92, or 92%. So on that day there was a 92% chance of a 50 basis point cut factored in. The percentage continued to rise until it was fully factored in by the meeting. When the FFF contract gets over 50%, you have to start banking on it.

Right now the February contract stands at 94530. As rates were cut 50 basis points, we use 94500 as our baseline. There is no real cut priced in for February. March stands at 94665 and that is factoring in a 34% chance of a 25 basis point cut. The April contract stands at 94940, a 100% chance of a 25 basis point cut, and a 76% chance of a 50 basis point cut by April.


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