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On Bloomberg this past Friday, there was an article that talked about the dollar. Whoever wrote the Bloomberg article wrote this:

“Traders are pricing in about an 82 percent chance the Fed will boost its key rate a quarter-point to 5.25 percent in its June 28-29 meeting, up from 48 percent at the end of last week, interest-rate futures show.”

Do you ever wonder where the hell did they get these numbers from? Where did “82 percent” come from? Did some big hotshot analyst just pull that number out of his as…uh head and then the whole world agreed?

Fortunately that’s not the way it actually works. There is a tool that the Federal Reserve Bank of Cleveland provides on their web site called the “Fed Funds Rate Predictions”. I’m not going to explain how the tool is made because it’s on the site and I don’t want to put you to sleep. What’s great about the tool is the Cleveland Feds provide pretty pictures that make trying to figure out what market expectations are for future interest rates a piece of cake.

(click to enlarge)

Here are the current predictions of what the Fed will do in their upcoming FOMC meeting this month. The current fed funds rate is at 5.00%. At this moment, on 06/11/06, there is an 82% chance that the Fed will raise raises to 5.25%. There is a 15% chance that the Fed will keep the rates unchanged at 5.00%. Pretty simple huh? It’s like reading your local weather forecast but instead of the probability of rain, it’s the probability of interest rate changes. How exciting!

So what causes interest rate expectations to change anyways?

If you look at the chart I’ve drawn vertical lines and labeled each one with a number. What do these lines signify? News off course! Or new information to be exact. Here’s what happened for each number:

  1. FOMC minutes revealed that Federal Reserve officials appear very worried about rising prices and expectations among consumers that prices will rise further. This boosted expectations that the Fed will continue to raise interest rates.
  2. The terrible nonfarm payrolls report. Nonfarm payrolls increased by 75,000 in May, lower than the 180,000 expected. This lowered expectations that the Fed will continue to raise interest rates and are “done”.
  3. Hawkish remarks by Federal Reserve Chairman Bernank. He tells an audience of bankers he is uneasy about so-called “core inflation” levels in the economy. This causes expectations for a rate increase to skyrocket!
  4. Existing home sales and the consumer confidence index unexpectedly rose.

Using a daily chart of EUR/USD, let’s see how changes in interest rates expectations affect the dollar.

The numbers at the bottom are the number of pips the currency pair increased or decreased from its open price.

Notice that when new information is released that raises expectations of a rate hike, the dollar appreciates. On this chart, since USD is the counter currency, the EUR/USD falls.

This works the same in the other direction as well. When new information is released that causes the market to lower expectations of a rate hike, the dollar falls. On this chart, since USD is the counter currency, the EUR/USD rises.