Monday 12 August 2019

Odds of another 100bps or more this year? 1 in 5.

I mentioned this morning that the options market was beginning to make some pretty exceptional progress on the way to pricing in 50bps+ at the September meeting. What's even more significant, in my mind, is what the market has done to the odds of additional easing in 2019. We're now 1 in 5 odds that the Fed delivers an additional 100bps by year-end.

September: Options Market-Implied probability of >25bps cut at September FOMC now about 75% (left of red line, was <10% day of July FOMC). OTC options mkt has odds of Fed unchd in September same as 75bps cut.

Odds calculated using the Eurodollar & OTC swaption mkt, fwd FRA/OIS spreads & fitted Fed Funds curve.
December: Options Market-Implied probability of at least 100bps additional cuts between now & the end of the year is about 20%. That's increased four-fold over the past two weeks. At the current pace of transformation to the probability distribution, we'll be pricing in odds of zero rates by the end of the month. 

Odds calculated using the Eurodollar & OTC swaption mkt, fwd FRA/OIS spreads & fitted Fed Funds curve.
For those looking for a more detailed way of thinking about "odds", a brief practitioners' guide below. 

First, the September "odds". The simplistic way to think about the pricing of odds for Fed cuts at upcoming meetings is to look at how many basis points lower that rate is versus the current spot rate. Right now, here's what those rates look like vs the 1-month "spot" rate.

What's currently priced into each of the 3 upcoming FOMC meetings.
In other words, the September FOMC is pricing in a total of 34.5bps, the October meeting is pricing in just over 2 "cuts" between now & then, and the December meeting is priced for just under 3 "cuts".

What's crucially important is this: just because the September FOMC has 34.5bps priced in, that doesn't mean that there's a 62% chance of a 25bps cut & a 38% chance of a 50bps cut.

If that were true, then that would mean you'd need to think there was 0% chance of the Fed staying on hold (it's low, to be sure, but nothing's 0% until it's realized) *and* more importantly 0% chance of the Fed cutting by any more than 50bps. Clearly, that can't be the case either. The Fed has routinely cut by more than 50bps in a crisis (the GFC, for example) and they will again. There's a better way of doing this, and it involves using the options market.

Using current Fed Funds curves & fwd FRA/OIS, we can fit all possible Fed "paths" between now & the end of this year to current mkt pricing of the Eurodollar & OTC swaption mkt. The resulting probability distribution returns a shape of the fwd OIS curve for each meeting.

Understanding I've likely lost 99% of the audience there, I'll leave further discussion for another time.