Interest Rate Hike Probability - What Gives?

 Recently, I've come across a lot of internet users claiming that interest rate hikes are priced in. When someone claims that an event is priced in, it means that the market has already adjusted in accordance with the event happening. Just to ensure that everyone is on the same page, an example would be worries about an economic recession. Data may show that a recession may be imminent, but earnings may not necessarily have been impacted yet. Despite this, stocks are still priced as if earnings have already taken a hit. The market is forward-looking, and the phenomenon of being "priced in" is no exception to that. 

Of course, if everything was priced in, then the market would simply be a flat line. The market's price is actually a product of market sentiment, taking into account the perceived probability of events. For example, if a stock was initially $10, and would drop to $9 during a recession, then should a recession have a 50% chance of occurring, then only a slight discount will be applied to reflect the uncertainty regarding the recession materialising, resulting in a price of $9.50. Obviously, this is an oversimplified example, but you get my point. 

It is no secret that the Fed has continually raised interest rates in recent times in an effort to cool the labour market so as to curb demand-side inflation, and stock prices have fallen to reflect that. However, there is no telling how many basis points would the Fed actually raise interest rates by until the commencement of the regular Fed meeting, resulting in uncertainty. Hence, this website intrigued me when it claimed to display the according rate hike probabilities priced in by markets:

https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html?redirect=/trading/interest-rates/countdown-to-fomc.html

Incredible. Various terminal interest rates sorted by probability priced in coupled with the respective meeting dates presented neatly for your viewing pleasure. Theoretically, with this information, you could predict where the market would go depending on the actual Fed meeting. If interest rates rise more than expected, then markets go down, and vice versa. My initial thoughts upon seeing this were: How do they actually calculate the probabilities? Hence, I promptly visited the website's "methodology" section to see what's their actual rationale. 

Just to preface, there is more to their methodology, but I concede that I cannot even begin to unpack the copious amounts of jargon and terminology used. However, my base case remains the same. In essence, futures are a tool for betting on certain price movements. In this case, Federal Funds Futures are bets on the interest rate. By using futures and derivatives information, the tool can more or less translate it to a probability table. 

In my humble opinion, do take the information presented by this tool with a pinch of salt, as futures traders are not representative of the entire market, and may relatively be more optimistic or pessimistic than the market in its entirety. Treating such a tool's content as gospel may be a dangerous game indeed. Nevertheless, I find this tool an interesting and potentially useful one to roughly gauge market sentiment, despite its inherent limitations. 

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Disclaimer: Please take everything published within this blog with a pinch of salt. Nothing I say here should be misconstrued as any form of financial advice whatsoever. In fact, I am probably the absolute last person you should approach for any sort of advice. All self-computed figures are calculated to the best of my ability, but I cannot guarantee they are 100% accurate.

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