A famous rule of the thumb in macroeconomics states that a currency tends to appreciate when interest rates applied by the domestic central bank increase and depreciate every time they fall. Empirical tests carried out on the historical series of the forex markets show how this assumption is true.
So how do you predict when a central bank will change its interest rate monetary policy? Let’s take the dollar. A useful tool is represented by the implicit probabilities of the fed funds published each day by the Commodity Merchantile Exchange through the FedWatch tool. The Fed Watch assumes that a probability of a rate hike is calculated by adding the probabilities of all target rate levels above the current target rate. Probabilities of possible Fed Funds target rates are based on Fed Fund futures contract prices assuming that the rate hike is 25 basis points and that the Fed Funds Effective Rate will react by a like amount. FOMC meetings probabilities are determined from the corresponding CME Group Fed Fund futures contracts.
The FedWatch tool calculates unconditional probabilities of Federal Open Market Committee meeting outcomes to generate a binary probability tree. CME Group lists 30-Day Federal Funds Futures futures, prices of which incorporate market expectations of average daily Federal Funds Effective Rate levels during futures contract months. The FFER is published by the Federal Reserve Bank of New York each day, and is calculated as a transaction-volume weighted average of the previous day’s rates on trades arranged by major brokers in the market for overnight unsecured loans between depository institutions.
A good strategy for dollar traders is choosing an investment horizon and see the implicit probabilities at the end of that period. By observing the related probabilities, a trader can see investors’ beliefs on the interest rate levels and go long/short with the dollar against other pairs. It is a medium term strategy which works especially under normal market conditions. Very rarely implicit probabilities are disattended by the actual FED’s decisions, when a probability is higher than 60-70%.