When it comes to finance, monetary policy is the quintessential market driver. No matter what you’re trading―equities, futures, bonds, or currencies―evolving monetary policy has a tremendous bearing on asset valuations.
Perhaps the most influential policymaker in the world is the U.S. Federal Reserve (FED). Let’s take a look at the CME FedWatch Index and how traders use it to account for future FED policy decisions.
So what exactly is monetary policy? It’s the action taken by a nation’s central bank to promote pricing stability and long-term economic growth. For the United States, the lead policymaking body is the Federal Open Market Committee (FOMC).
The FOMC consists of five Reserve Bank presidents and the seven members of the FED’s Board of Governors. According to the FOMC’s congressional mandate, its role in fostering economic stability is to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy.
In working toward these goals, the FOMC meets eight times per year. At each meeting, the directors scrutinize the state of the global and U.S. economy and capital markets. They then craft policy based on three primary functions:
Each of these devices is designed to expand or contract the supply of U.S. dollars in various ways. However, the most-referenced aspect of FOMC policy is the Federal Funds Target Rate. This is where the CME FedWatch tool comes in: It represents market sentiment toward the potential for interest rate adjustments conducted by the FOMC.
The Federal Funds rate is the most influential interest rate facing the U.S. economy. As a result, many traders and investors buy or sell 30-day Fed Fund futures to account for short-term rate fluctuations. These contracts are listed monthly and serve as the basis of the CME FedWatch Index.
Any trades are educational examples only. They do not include commissions and fees.
Thirty-day Fed Fund futures contracts are priced on a scale of 0-100, with current market expectations subtracted from 100. For instance, if the market projects the Federal Funds rate for June to be 2 percent, June 30-day Fed Funds futures would be priced at 98 (100-2=98). The CME then aggregates this data and assigns a probability to specific rate adjustment scenarios for upcoming FOMC meetings. In this way, traders are able to quickly view the chances of an FOMC rate adjustment at a specific point in time.
One of the benefits of the CME FedWatch tool is that it is user-friendly. To illustrate its functionality, assume that Erin the equities trader is concerned about a September 2020 rate hike derailing an ongoing stock market rally. Erin accesses the CME’s online portal and clicks on the tab (in this case, the 16 Sep20 tab) within the FedWatch tool.
An easy-to-read bar chart that includes the current Fed Funds Target rate (in basis points, bps) and possible hike or cut scenarios is automatically produced. A probability is assigned to each event, with the percentage clearly expressed at the top of the corresponding bar.
The CME FedWatch Index is extremely useful for monitoring the probability of upcoming FOMC policy moves. Probabilities of rate hikes or cuts are made clear, with daily, weekly, and monthly changes listed. Although no analytical device is infallible, the FedWatch tool is a solid way of projecting future FED policy.
Staying abreast of how monetary policy influences the markets is a full-time job. That’s why many professional futures traders choose to outsource the analytics to an independent information provider.