Measuring Market-Implied Policy Expectations

Fed funds futures accurately predicted the direction of 47 of the last 50 rate decisions—but the magnitude and timing of changes often surprised markets. In December 2021, futures implied zero rate hikes through March 2022; the Fed ultimately delivered +75 bps by that point (CME Group, 2022). The practical point: market-implied expectations are the best available consensus forecast, but they embed risk premiums, liquidity effects, and model assumptions that can mislead.

Fed Funds Futures: The Core Instrument

Fed funds futures are contracts traded on the CME that settle based on the average effective federal funds rate (EFFR) during a specific month. Each contract covers one calendar month.

Contract mechanics:

• Contract size: $5 million notional
• Pricing: 100 minus the implied average fed funds rate
• Settlement: Cash-settled against the monthly average EFFR

Example: If the January 2026 fed funds futures contract trades at 95.75, the implied average fed funds rate for January is:

100 - 95.75 = 4.25%

This means the market expects the effective fed funds rate to average 4.25% during January 2026. If the current target range is 4.25-4.50% with EFFR trading around 4.33%, the futures price implies expected easing.

The point is: futures prices translate directly into rate expectations without complex modeling—just subtract from 100.

Extracting Meeting Probabilities: The CME FedWatch Method

The CME FedWatch tool converts futures prices into probabilities for specific rate decisions. The methodology relies on the fact that FOMC meetings occur at known dates, dividing each month into "pre-meeting" and "post-meeting" periods.

Step 1: Identify the meeting date

Suppose the FOMC meeting is January 29, 2026. January has 31 days, so:

• Pre-meeting period: Days 1-29 (29 days)
• Post-meeting period: Days 30-31 (2 days)

Step 2: Calculate the implied post-meeting rate

The January futures price reflects the weighted average of rates before and after the meeting:

January futures rate = (Pre-meeting days × Pre-meeting rate + Post-meeting days × Post-meeting rate) / 31

If we know the pre-meeting rate (the current target) and the January futures rate, we can solve for the implied post-meeting rate.

Step 3: Convert to probabilities

If the current target midpoint is 4.375% and the implied post-meeting rate is 4.25%, the implied change is -12.5 bps. Since the Fed moves in 25 bp increments:

Probability of -25 bp cut = 12.5 / 25 = 50% Probability of no change = 50%

Worked Example: Calculating a 3-Meeting Rate Path

Suppose today is December 15, 2025. Current fed funds target: 4.50-4.75% (midpoint 4.625%).

December meeting (Dec 17-18):

• Pre-meeting: 17 days at 4.625%
• Post-meeting: 14 days at implied rate
• Solving: (17 × 4.625 + 14 × X) / 31 = 4.65
• X = 4.68% (essentially unchanged)

Probability: ~0% chance of cut in December, ~100% hold

January meeting (Jan 28-29):

• Start rate: ~4.625% (unchanged from December)
• Implied January average: 4.45%
• Using 29 pre-meeting days and 2 post-meeting days:
• Solving: (29 × 4.625 + 2 × X) / 31 = 4.45
• X = 4.125% implied post-meeting rate

The implied cut is -50 bps from 4.625% to 4.125%, suggesting:

• ~50% probability of -50 bp cut
• ~50% probability of -25 bp cut
• (Weighted average produces the -50 bp implied move)

March meeting (Mar 18-19):

• Start rate: ~4.125% (after January cut)
• Implied March average: 4.25%
• With 18 pre-meeting days and 13 post-meeting days...
• The calculation suggests another ~25 bp cut priced in

3-Meeting Rate Path Summary:

The durable lesson: read the rate path as a probability-weighted average, not a point forecast. Markets aren't predicting "definitely 25 bps"—they're pricing a distribution of outcomes.

OIS Curves: Longer Horizon Expectations

Overnight Index Swaps (OIS) extend rate expectations beyond the near-term futures contracts. In an OIS, one party pays a fixed rate and receives the compounded overnight rate (SOFR in the U.S.) over the swap term.

How OIS works:

• 1-year OIS rate: Market's expectation for the average overnight rate over the next 12 months
• 2-year OIS rate: Average overnight rate expectation over 24 months

Reading the OIS curve:

If the current fed funds rate is 4.50% and the 2-year OIS is 3.50%, markets expect cumulative easing of approximately 100 bps over two years.

The practical point: OIS curves smooth out meeting-by-meeting noise and show the expected rate trajectory over longer horizons. Use fed funds futures for near-term meeting probabilities; use OIS for the multi-year path.

Pitfalls: Why Market Pricing Can Mislead

1. Risk Premium

Futures prices embed a risk premium for interest rate uncertainty. This premium tends to be positive (futures rates slightly above expected rates) because rate volatility hurts leveraged positions. Studies estimate this premium at 3-8 bps per contract (Piazzesi and Swanson, 2008).

Implication: Futures-implied rates may overstate expected rates by a small amount. A futures rate of 4.25% might reflect an expected rate of 4.20% plus 5 bps of risk premium.

2. Liquidity and Technical Factors

• Roll effects: As contracts approach expiration, liquidity shifts to the next month, causing short-term price distortions
• Dealer positioning: Large hedging flows can move prices temporarily away from fundamental expectations
• End-of-quarter effects: Regulatory constraints cause rate spikes at quarter-end that distort monthly averages

3. Model Assumptions

The probability calculations assume:

• The Fed moves in 25 bp increments (usually true, but 50 bp and 75 bp moves occur)
• No intra-meeting rate changes (rare but possible in crises)
• The current rate is known with certainty (EFFR fluctuates slightly within the target range)

4. Consensus, Not Prediction

Market pricing reflects the weighted average of many different views. If half of traders expect a 50 bp cut and half expect no change, the futures price implies 25 bps—an outcome no one actually expects.

The test: when implied probabilities are close to 50/50, the market is genuinely uncertain. Don't interpret this as a confident 25 bp forecast.

Practical Workflow for Using Market Expectations

Step 1: Check the current rate environment

• Note the current fed funds target range
• Calculate the midpoint for baseline comparison

Step 2: Pull futures-implied rates

• CME FedWatch tool provides meeting-by-meeting probabilities
• Check 3-6 months ahead for near-term path

Step 3: Assess confidence levels

Step 4: Compare to Fed communication

If markets price 75% probability of a cut but recent Fed speeches are hawkish, one side will be surprised. Identify the disconnect before the meeting.

Step 5: Monitor changes over time

Track how probabilities evolve as data releases arrive. Shifting expectations—not static levels—often drive market moves.

Interpreting the FedWatch Tool

The CME FedWatch tool displays:

Target Rate Probabilities: Percentage chance of each possible target range after the meeting

Example output:

• 4.25-4.50%: 15%
• 4.00-4.25%: 60%
• 3.75-4.00%: 25%

This distribution shows the market expects a cut (85% combined probability of lower rates) with the modal outcome being the 4.00-4.25% range.

Implied Rate: The probability-weighted average target rate

Implied Change: Expected bps change from the current target

Common misreads:

• Treating modal outcome as certain (60% means 40% chance of something else)
• Ignoring distribution width (tight distribution = high confidence; wide = uncertain)
• Assuming market is always right (historically accurate on direction, less on magnitude)

Your Monitoring Checklist

Essential (before each FOMC meeting)

• Check FedWatch probabilities for the upcoming meeting
• Note the probability of the modal outcome (>80% = high confidence)
• Compare to the last statement and press conference tone

High-impact (monthly)

• Review 6-month futures strip for cumulative expected moves
• Compare OIS curve to 3 months ago to see how expectations shifted
• Note any large single-day moves in probabilities following data releases

For active traders

• Track intraday probability changes around key data (CPI, payrolls)
• Monitor risk premium estimates from academic sources
• Compare dealer positioning reports to implied probabilities

Your Next Step

Visit the CME FedWatch tool (cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html) and note the probability of a rate change at the next meeting. Then calculate how much cumulative easing or tightening is priced over the next 6 months by summing the implied moves across meetings. This exercise takes 10 minutes and gives you the market's baseline forecast to compare against your own view or the Fed's dot plot.

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Related: Forward Guidance and Dot Plots | Understanding SEP and Economic Projections | How Policy Moves Impact Yield Curves