How does the market “price in” changes in the interest rate?
Where can this “pricing-in” be observed? For example, when they say, “the market is pricing in two more 0.25% hikes in the next 12 months” etc.
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Believe you can look at the fed funds futures rate for whichever time period you are trying to observe and then calculate the probabilities required to reach that point. Just a very crude example and I’m no expert but lets say fed funds futures (12 month contract) is 5.9% and we are currently at 5.25%. This implies that the market has fully priced in 2 25bps hikes or an equivalent 50bps hike. Then the remainder is (5.9% - 5.75%) = 15bps. 15bps/25bps is the probability of the third 25 basis point hike. That’s the type of logic that goes into these calculations. These aren’t necessarily real probabilities but I think risk-neutral probabilities. There is an article on the WSJ that explains this quite well. (Not sure if link works)
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Yes to the above, this is also a good explanation Understanding the CME Group FedWatch Tool Methodology - CME Group
BBG has a function showing directly how many hikes/cuts have been priced in by the curve.
If you have access to a Bloomberg, use the WIRP function.
This. This concept was pretty foreign to me for the longest time, then I saw WIRP and it made things so much clearer. Also compare this to ICVS 490 under different tenors (forward curve for Term SOFR) and you’ll see the relationship between hikes and rates.
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