One of the most popular datapoints in markets is the Fed Funds Futures estimate of the number and size of Fed interest rate hikes or cuts. The average estimate is about four rate cuts in 2025, with an expected year-end Fed Funds rate of 3.4%. This market-implied base case scenario is one that investors will probably find favorable.
Possibly more important is the distribution of the Fed Funds Rate expectations. In the chart below we use options prices to estimate the market’s implied distribution of outcomes. This leads to a few important observations:
1.Options markets imply large variability around the base case.
2.Options prices imply a sizable probability that the Fed does not cut interest rates at all in 2025 and may even be forced by higher prices to raise rates
3.Options markets also show a sizable chance that the Federal Reserve will need to aggressively cut rates this year, implying disappointing economic growth.
The mean expectation instructs on the base case, but it does not provide context around the risks to the base case. In finance and for investment strategy, thinking probabilistically about the size and shape of the distribution of outcomes compliments knowing the mean expectation. This is especially important today, given the significant probability that the base case may be wrong.