Why The FedWatch Tool Became a Key Interest Rates Indicator

Predictions about the Federal Reserve’s plans for its Federal Funds rates are not hard to find. Turn on any form of financial news and there’s no shortage of prognosticators discussing where the Fed will take rates.

But there’s another widely cited gauge increasingly used by traders to get a read on the next move for rates. FedWatch, a tool from CME Group, has become a favorite indicator to assess where overnight rates will go as the Fed works to tackle stubborn inflation.

The tool has been around for roughly a decade when CME Group introduced it to make futures prices more accessible and transparent for market participants. 

“FedWatch was created in the spirit of providing efficient tools to help our clients manage interest rate risks in a transparent and cost-efficient way,” said Agha Mirza, Global Head of Rates & OTC Products at CME Group, adding that he and his team launched the indicator after clients showed an appetite for it. 

Relying on 30-day Fed Funds’ futures prices, the tool uses this data to display both current and historical probabilities of various FOMC rate outcomes for a specific meeting date. Probabilities are based on Fed Funds futures contract prices, assuming that hikes/cuts are sized in 25bps increments. The FedWatch tool also shows the Fed’s “Dot Plot” targeting FOMC members’ expectations for benchmark rates over time. 

Fed Funds futures volumes have soared in 2023. Through May, an average of 550,000 contracts traded daily, up from 333,000 in 2022. Daily futures volume soared to 2.6 million contracts around the date Silicon Valley bank went bankrupt, the highest on record, adding to eight days where it has exceeded 1 million contracts in 2023.

FedWatch isn’t just for traders. Media mentions for FedWatch have also surged. In the second quarter of 2023, mentions were up 308% from 2022 as top financial media from Bloomberg to CNBC to MarketWatch cited the tool as the preferred gauge to help investors predict the future of U.S monetary policy.

“The tool assumes that overnight rates are on average constant between FOMC meeting dates and that rate moves are in multiples of 25 basis points, it then creates a pathway of predicted overnight Fed Funds rates,” Mark Rogerson, EMEA Head of Interest Rate Products at CME Group, explained. “That pathway is used to calculate probabilities of what will occur around FOMC meeting dates.”

The gauge expresses the totality of what most Fed Funds traders expect will happen during FOMC meetings so it’s therefore seen as an accurate and unbiased barometer of where prices will head. 

FedWatch has proven a useful tool for when expectations move suddenly based on news of the day. For example, the tool estimated a much higher probability of a 0.5% hike than a 0.25% hike immediately following Congressional testimony from Fed Chair Jerome Powell on March 7. Following the Silicon Valley Bank failure and intervention from the FDIC and Federal Reserve days later, expectations for the March 22 FOMC meeting moved strongly back to the 25-bps expectation.

Currently, FedWatch is showing a higher chance that the FOMC will start cutting rates in September. Likely drivers of this are banking industry turmoil and easing inflation, which could lower the need for further hikes. The Fed Funds rate puts a price on money by determining what banks charge to borrow from each other, affecting a plethora of consumer and business loans.

Treasury futures volatility is another measure traders can watch as rate expectations change. CME Group also offers the CVOL volatility indexes that track volatility across 2-, 5-, 10- and 30-year treasuries.