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Forward Guidance From the Market: Reading Interest Rate Futures

Central banks tell you what they intend. Interest rate futures tell you what the market believes they will do. Comparing the two is one of the most useful habits in fundamental analysis.

Futures contracts on short-term rates, such as the fed funds futures or similar contracts for other currencies, trade at prices that imply an expected rate on a future date. Many data providers convert these into probabilities of a rate hike or cut at the next meeting, and into the expected rate path.

For example, if the implied probability of a 25-basis-point hike at the next meeting is 90 percent, a hike is largely priced in. If the central bank holds, the currency will likely fall sharply, since the market was positioned for a hike.

The expected path also matters. A central bank may deliver a hike but suggest it is the last, while the market expected three more. The currency may fall despite the rate rise.

Tracking changes in expected rates over time gives a view of how data releases shift expectations. A strong employment report that raises the probability of hikes tends to strengthen the currency.

These tools are available on public websites for major economies, including free probability trackers.

Interpret them with caution, as probabilities shift quickly and are not forecasts.

Practical step: before the next central bank meeting, record the market-implied probability and compare with the actual decision and price reaction.

The free probability trackers are worth bookmarking. Checking them the day before a meeting tells you whether a decision is a surprise or a non event before it happens. CME FedWatch is the well known one for the Fed, and there are similar tools or market summaries for the ECB and Bank of England. If the market has a 95 percent chance of a hold priced in, a hold won't move much and the focus shifts to the statement and press conference. If it's closer to 50/50, the decision itself becomes the event and the reaction can be big either way. That one check tells you how to plan the day.

Watching how the probabilities change after big data is a great way to learn what the market cares about. Payrolls or CPI that shifts the odds a lot is a release worth respecting next time. Try it for a month. Before each big US release, note the probability of a cut or hike at the next meeting, then check it again an hour after. Some releases barely move it, others swing it by twenty or thirty points. The ones that move it are the ones that move the dollar, and they change over time depending on what the Fed is focused on. Inflation mattered most for a while, then jobs data took over.