Beyond a Coin Flip: Market prediction in overdrive on single Fed decision
Wall Street speculators waited idly for some 80 months as the US Federal Open Market Committee held staunchly by their pledge to hold baseline interest rates* near 0. Throughout this unprecedentedly long stretch of steadfast easy money policy, the committee communicated their plans time and again, effectively eliminating any talk of rate changes and minimizing speculation. The long awaited end of their zero-rate commitment earlier this year opened up the floodgates to an all-encompassing outpour of debate on the precise timing of the rate change. Fund managers, desk traders and economists far and wide have all offered up their opinions on when such a revision will occur, and while the social benefit to all this narrowly focused effort may rightly come into question, we can nonetheless look to this process as an ideal demonstration of prediction markets as information aggregators.
A report regarding the upcoming FOMC meeting recently surfaced that alleges, on the whole, the financial markets place the likelihood of an imminent rate hike at 74 percent. The method of arriving at this exact number involves changes in Treasury bill and other security prices, but the specifics are not pertinent for this discussion. A few simple conditions show how speculating – or “gambling”, depending on who you ask – on debt securities that directly change in response to the Fed’s decision is not unlike betting on race horses. Enormous amounts of Treasury debt are traded everyday, the defining traits of each security being its price and corresponding (but inversely related) yield. The important point here is that a Fed target rate hike would imply greater yields and thus lower prices. Accordingly, in the weeks, days, and hours leading up to the announcement, traders’ willingness to buy and sell this debt at some price depends on their opinion on the future rate decision; a correct prediction about the swing in debt prices affords a quick and potentially hefty profit.
In the same way odds are not spread evenly and uniformly over a field of horses, Treasury debt prices do not indicate a perfect 50-50 chance of a rate change. The prices move according to supply and demand, so when the bulk of money enters a position in the market, the underlying belief behind those bets more substantially impacts the debt prices. Additionally, if we justifiably disregard potential debt defaults, debt markets mimic other prediction markets in that all money invested is also fully paid out. Consequently, speculation on treasury debt will follow the wealth share weighted average of beliefs, with the inverse odds of the rate hiked directly relating to bettors’ beliefs and respective weight of their bet amongst the whole. On a weighted average basis, then, the consensus likelihood of 74% on a rate hike entails odds of 1/.74 ≈ 1.35, and implies that an investor who buys $1,000 worth of Treasury debt at current prices would expect to see her investment value rise to $1,350 in the event of such a announcement.
Information with the potential to influence the Fed’s decision continues be released seemingly every day, making it easy to be left behind and out of touch on the latest debt price swings.
*Target Federal Funds rate, which has been held in a range of 0.00% – 0.25% since 2008.
Reference: http://www.bloomberg.com/news/articles/2015-11-24/fed-rate-odds-rise-to-74-in-bond-market-as-pimco-sees-liftoff