Inferring Central Bank Rate Expectations from Interest Rate Derivatives
Summary
The document describes how market expectations for a central bank decision can be inferred from liquid interest rate derivatives whose accrual dates closely match the period between policy effective dates. The suggested approach is to identify a tradable instrument aligned with the policy period and interpret its quoted rate after accounting for the spread between that instrument’s reference rate and the current policy rate.
A worked example uses a meeting-dated overnight rate swap and an observed stable differential to infer an expected policy rate. Under an assumed set of discrete decision outcomes, the implied rate can then be expressed as probabilities across those outcomes. The method explains how market pricing can produce statements about likely rate moves and can be reconstructed from public rate observations, but the example is for another central bank and does not directly answer the Bank of Canada case. The inference depends on instrument liquidity, alignment of dates, stability of the reference-to-policy spread, and assumptions about possible decision sizes; it is a market-implied expectation, not a guaranteed forecast.
Key ideas
- Use liquid derivatives whose effective and end dates align with central bank policy periods to read market pricing.
- Adjust the derivative-implied reference rate for its typical spread to the policy rate.
- Translate the resulting implied rate into outcome probabilities only after specifying possible decision sizes.
- Market-implied probabilities depend on date alignment, liquidity, spread stability, and modeling assumptions.
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Full text
# Understanding how markets predict BoC's policy interest rate decisions # Understanding how markets predict BoC's policy interest rate decisions I read in the newspaper things like, > Interest rate swaps, which are based on market expectations about future rate decisions, are pricing in at least one Bank of Canada rate cut later this year, and additional cuts in 2024. Sometimes there will be a probability associated with the prediction, ie. markets are saying that there is 80% chance of decrease to 4.75% the next time the central bank announces its policy interest rate. My understanding is that there are a few ways of making these predictions, ie using bankers' acceptances or overnight index swaps. Is there a generally accepted belief that one method has greater prediction accuracy than other methods? Specifically, I'm interested in understanding what and how the markets are predicting for the next Bank of Canada decision for its policy interest rate. More Questions - Where exactly do these predictions come from? - Can they be recreated by publicly available information? - If so, can someone point me in the right direction as to how to do this? ## Answer by Attack68 (score 4) https://quant.stackexchange.com/a/74581 I trade interest rate derivatives. I can definitively tell you the best way of analysing what is priced in is to identify the liquid and tradeable instruments that most closely aligns with the central bank rate and observe what the price is for that instrument. In many currencies, GBP, EUR, SEK, NOK, probably USD, there are RFR IRS derivatives that have effective and termination dates that fall exactly between the central bank policy effective dates. Take Sweden as an example. On Thursday this week (9th Feb 23) they will announce their policy which will apply to the effective dates of Wed 15th Feb 23 to Wed 3rd May 23. The price of the so called "Feb meeting SWESTR" is 2.92%. The current SWESTR prints consistently at 2.385, when the central bank policy rate is currently 2.50. That means a stable differential of 11.5bps. If you infer the central bank policy rate from 2.92% you get 3.035%, i.e. between the two outcomes of a 50bps hike and (if you assume quarterly point jumps) 75bps then the probabilities are 86% and 14%.
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