Probabilities are Accurate Until They Aren't

Almost everything in your life can be viewed as an event with a probability. What are the chances your local grocery store has the item you’re looking for? What’s the likelihood of running into so-and-so if you go to this bar as opposed to that one? What’re the odds you miss your flight if you leave at X:YZ o’clock?

What do all the probabilities in your life have in common? They’re all dynamic - constantly changing. At the conclusion of the event a binary 0% or 100% is realized, but the journey to that ending can witness wild swings in either direction.

Super Bowl LI between the New England Patriots and Atlanta Falcons is a prime example of just how much probabilities can change. The Win Probability reached more than 95% for both teams before the Patriots won in overtime.

While probabilities around the market might not shift so extremely, the Fed and their odds of future interest rate hikes are giving even Tom Brady a run for his money.

Fed Funds futures (ZQ) are derivatives based on the Fed Fund Rate and their prices generally project what the Fed will do in the future. For example, the December 2022 ZQ futures contract trading at 96.50 means that the market currently thinks interest rates are most likely going to be 3.5% (ZQ futures are priced in a manner that 100-[ZQ Price]=Interest Rate) at the end of the year.*

In the Summer of 2021, it was projected that rates would still be close to 0% by 2022’s close; and, while the path between 0% and 3.5% has been a volatile one, the journey isn’t over yet!

The current projection of a 3.5% interest rate at the end of 2022 is likely to change between now and December. In just the last week of trading, the most probable outcome has gone from leaning over 3.5% to now a shade under it.

It may not look like much, but a 25 basis point (bps) shift is considered quite volatile for just a week’s worth of trading; extrapolating such volatility over still half a year left to trade, it could be reasonable to expect another 125 bps shift in either direction before the Fed actually speaks in December.

Assigning odds to life’s events can help in the decision making process, but thinking that the future cannot deviate from the most likely outcome projected today is delusional. Probabilities change, and spotting an inefficiency before the rest of the market can make for some of the best trades.

Sign up to start receiving free analysis on everything from stocks and bonds to commodities and foreign exchange.