Personally, I don't use the CME Fedwatch to assess the full probability distribution, which (agreeing with your analysis) appears to assign too low probabilities to extreme outcomes. I do use it to gauge the median expectations implied the market. And I think it does an ok job at that - it generally accords with short-term bond yields after all.
Hi Preston, thanks for the feedback! I am going to update this post with a few more charts and links to better sources that give a more accurate picture than CME Fedwatch. In general, CME Fedwatch is using futures prices to derive a probability distribution. But futures prices reflect the probability-weighted average of options pricing, and you can't derive a probability distribution from an average. Options prices give you probabilities, and SOFR quarterly options are liquid enough that you should always use those instead. A great free resource for options pricing is provided by the Atlanta Fed: https://www.atlantafed.org/cenfis/market-probability-tracker. If you are using CME Fedwatch to track the next meetings odds, you will generally be fine, but in a situation like the fall of 2008 - where the range of outcomes for what the fed might do in a short amount of time is wide - CME Fedwatch will fail you.
Personally, I don't use the CME Fedwatch to assess the full probability distribution, which (agreeing with your analysis) appears to assign too low probabilities to extreme outcomes. I do use it to gauge the median expectations implied the market. And I think it does an ok job at that - it generally accords with short-term bond yields after all.
Hi Preston, thanks for the feedback! I am going to update this post with a few more charts and links to better sources that give a more accurate picture than CME Fedwatch. In general, CME Fedwatch is using futures prices to derive a probability distribution. But futures prices reflect the probability-weighted average of options pricing, and you can't derive a probability distribution from an average. Options prices give you probabilities, and SOFR quarterly options are liquid enough that you should always use those instead. A great free resource for options pricing is provided by the Atlanta Fed: https://www.atlantafed.org/cenfis/market-probability-tracker. If you are using CME Fedwatch to track the next meetings odds, you will generally be fine, but in a situation like the fall of 2008 - where the range of outcomes for what the fed might do in a short amount of time is wide - CME Fedwatch will fail you.