How Wall Street Makes Money by Predicting the Fed’s Decisions?

At any given moment, curious about what the Federal Reserve might do in its upcoming meetings until the end of 2024? Look no further than the Chicago Mercantile Exchange Group‘s (CME Group) Fed Watch Tool page. This tool provides invaluable insights into the consensus predictions of traders regarding rate hikes, cuts, or no changes in interest rates at forthcoming meetings. Despite lacking insider information or crystal balls, the traders’ predictions have an impressive track record, which might suggest that even Fed Chair Jerome Powell keeps an eye on the Fed Watch Tool.

Deciphering Traders’ Predictions

The Federal Reserve’s decisions significantly impact the economy, and traders closely follow these actions. When the Fed changes interest rates, it alters the federal funds rate target range, impacting interest rates across the financial landscape, from bank-to-bank lending rates to consumer loan rates, including mortgages.

Since the late 1980s, investors have been trading Fed fund futures contracts, which are essentially bets on how the Fed will adjust interest rates in upcoming meetings. However, it wasn’t until 2013 that the CME Group launched the Fed Watch tool, democratizing access to this information without the need for complex calculations.

How the FedWatch Tool Works

Trading fed funds futures contracts resemble other futures contracts, with traders speculating on whether an asset will reach a specific threshold at a specified time in the future. Unlike typical futures contracts, traders use fed fund futures contracts to hedge their portfolios against market volatility tied to interest rate decisions. Because these trades are based on traders’ expectations about interest rates, the CME Group can aggregate this information to create a clear chart forecasting interest rate decisions.

Agha Mirza, CME Group’s global head of rates and OTC products, explains that the FedWatch Tool “translates the information that is embedded in [the Fed Fund Futures] trillion-dollar market into probabilities that people can make sense of.” It also tracks how investor sentiment changes following important data releases like the Consumer Price Index and monthly jobs reports, as well as remarks from Fed officials.

The Significance of the FedWatch Tool

The Federal Reserve’s interest rate decisions hold considerable weight in the world of investments. Investors closely monitor the FedWatch Tool to strategically position their portfolios based on expectations of how the market might react to Fed actions. According to Alex McGrath, Chief Investment Officer at NorthEnd Private Wealth, the Fed generally seeks to avoid decisions that contradict market expectations. When they do so, it can trigger heightened market volatility, as seen in the aftermath of Powell’s Jackson Hole speech last year when he took a more hawkish tone than expected, causing a 1,000-point drop in the Dow.

Why the Fed Tries to Align with Market Expectations

Going against market expectations can be counterproductive and have negative consequences for the economy. Greg Daco, Chief Economist at EY-Parthenon, explains that such actions can offset the impact of monetary policy by affecting business investment, consumer spending, or residential investment. To mitigate these effects, Fed officials frequently make public remarks to signal their intentions and provide forward guidance on future decisions. This approach allows investors more time to prepare and helps stabilize markets.

McGrath suggests that Fed officials likely monitor the FedWatch Tool to gauge how they should address market expectations. In line with their long-stated goals of maintaining stable employment and low inflation, they aim to prevent excessive market volatility, which plays a pivotal role in achieving their objectives.