Will the US Fed cut interest rates this week? Here’s what the markets think

The US Federal Open Market Committee (FOMC) is meeting this week. On Wednesday, the Chairman of the Federal Reserve (Fed) will give a press conference to discuss the highlights of this meeting. At this time, he will announce whether the federal funds rate will remain at the target of 5.25% - 5.50% or be cut by 25 basis points (bps). This is of particular concern for not just the US markets, but also for international markets as central banks across the globe may adjust interest rates following this announcement.

Interest rates in the US have been hiked 11 times since March 2022 to reduce inflation caused by the loosened monetary policy throughout the pandemic. While inflation has fallen, it isn’t quite at target levels. When interest rates are low, it is cheaper to take loans to buy houses, cars and other discretionary goods. In turn, this is a positive for the company's bottom lines leading to higher stock prices. Because of this, investors and markets anxiously anticipate when the rate cutting will begin.

Understanding the market implied chance of rate cut

So, what are the odds that rates will be cut this week? You don’t have to be an expert in monetary policy to get an idea of the likelihood of interest rate cuts or hikes; you only need to look at the federal funds futures prices to estimate what the market is implying. Federal funds futures contracts are traded on the Chicago Mercantile Exchange (CME) and allow traders to speculate or hedge on what the interest rate will be in any given month. The prices are based on the average effective federal funds rate rather than the current federal funds rate. The contracts are priced as 100 minus the average effective federal funds rates. The average effective fed fund rates are not necessarily the same as the current fed fund rates. For instance, let’s assume that the current rate is 5.00% and the contract price for the month following a FOMC meeting is 94.875. This means that the average effective fed funds rate is 5.125 (100 - 94.875).

Taking this example one step forward, the market is implying that the future rate will be higher (5.125%) than the current rate of 5.00%. If the market believed that the future rate would be the same, then the futures contract price would be 95.00. At a price of 95.00, then the average effective fed funds rate would be 5.0% and equal to the current fed funds rate. When the Fed decides to hike or cut interest rates, they typically do this in increments of 25 bps. In our example, 12.5 bps is halfway between 0 bps and 25 bps. Therefore, the market is implying a 50% chance of keeping interest rates flat and 50% chance of hiking interest rates by 25 bps.

So, what is the market saying right now?

The current federal funds rate target is 5.25% to 5.50%. The midpoint between this target is 5.375%. If the Fed were to reduce the target by 25 basis points, then this midpoint would be 5.125%. The March Fed Funds futures contract is priced at 94.67 and the April federal funds futures price is 94.675. Based on these prices, the March average effective federal funds rate is 5.330% and the April average effective fed funds rate is 5.325%. Since the April contract expires after the FOMC decision this week, then the market has taken any potential expected rate move into account. The March and April average effective rates are lower than the current 5.375% rate but not near the 5.125% rate of a rate cut. This implies a very low likelihood of a rate cut on Wednesday. Specifically, based on Friday’s fed funds futures prices, the market is implying between a 2-3% likelihood of a rate cut on Wednesday.