Market-Implied Rate Paths: Reading OIS Curves, €STR and SOFR Futures, and What 'Pricing in 50 Basis Points of Cuts' Means

What you will learn

• Why an overnight index swap (OIS) rate equals the expected average policy rate.
• How €STR and SOFR futures are quoted and converted into rates.
• How to calculate meeting probabilities, the cumulative path and a forward rate.
• Why "50 basis points of cuts priced" is an average, not a forecast.

Explanation

The reference rates

€STR (euro short-term rate) measures what banks pay to borrow overnight unsecured in euros; it sits a few basis points below the deposit facility rate. SOFR (Secured Overnight Financing Rate) is the US equivalent, based on overnight repo against Treasuries. Fed policy is expressed as a target range for the federal funds rate, so US traders use fed funds futures for meeting pricing.

Overnight index swaps

In an overnight index swap one side pays a fixed rate for a period and the other pays the compounded overnight rate realised over that period. For the swap to be fair at the start, the fixed rate must equal the expected compounded average overnight rate over the period, plus a small risk premium that is negligible up to one or two years. The OIS curve is therefore the cleanest picture of the market-implied policy path. Meeting-dated OIS run from one policy meeting to the next and isolate the expected rate in between.

Futures quotation

Three-month €STR futures and three-month SOFR futures are quoted as price = 100 − implied rate: 98.40 implies 1.60% for the contract's three months. One basis point is worth €25 or $25 per contract. Fed funds futures are quoted the same way on the monthly average rate. Check the exchange specifications; contract details change.

From price to probability

If the current overnight rate is r0 and the meeting-dated OIS for the period after the next meeting is r1, then the basis points priced for that meeting are r0 − r1. Assuming the choice is between no change and a 25 basis point cut:

probability of a 25 bp cut = (r0 − r1) ÷ 0.25

This is a convention: 18 basis points priced can mean 72% odds of 25, or a mix of 25 and 50 scenarios. Treat it as the market's weighted average.

Worked example

Hypothetical example: deposit rate 2.00%, €STR assumed equal to it. Meeting-dated OIS: after meeting 1: 1.82%; meeting 2: 1.65%; meeting 3: 1.52%; meeting 4 (year-end): 1.50%. Spot OIS: 6-month 1.80%, 12-month 1.60%. Costs ignored.

Step 1 – meeting 1: 2.00 − 1.82 = 18 basis points priced; probability of a 25 bp cut = 18 ÷ 25 = 72%.

Step 2 – cumulative: meeting 2: 2.00 − 1.65 = 35 bp; meeting 3: 48 bp; year-end: 50 bp. "The market prices 50 basis points of cuts by year-end" means an expected year-end rate of 1.50%, two cuts on average.

Step 3 – shape: 18, then 17 more, then 13, then 2. Two cuts are likely, the third is a coin toss, nothing after.

Step 4 – forward from spot OIS: the 6-month rate six months forward solves (1 + 0.0160 × 1) ÷ (1 + 0.0180 × 0.5) − 1 = 1.0160 ÷ 1.0090 − 1 = 0.694% for half a year, or 1.39% annualised (the simple approximation (1.60 × 12 − 1.80 × 6) ÷ 6 = 1.40% is close enough for day-to-day work). The second half of the year is priced at 1.39%, consistent with the meeting ladder.

Step 5 – futures check: a three-month €STR future covering the period after meeting 3 trades at 98.48 → implied 1.52%, matching the OIS.

Step 6 – the surprise: the ECB cuts 25 at meeting 1 but signals a pause, and year-end pricing moves to 1.70%: 20 basis points of cuts removed. Short-dated yields rise even though the bank cut. The decision was dovish, the repricing hawkish.

Common mistake

Practice activity

On paper: the Fed's effective rate is 4.30% (hypothetical). Fed funds futures for the month after the next meeting trade at 95.90; for the month after the following meeting at 96.15; the 12-month OIS is 3.70% and the 6-month OIS is 4.00%. (a) Rate implied by each future and basis points priced for each meeting. (b) Probability of a 25 bp cut at the next meeting. (c) The 6-month rate six months forward, simple approximation. (d) The Fed holds and says cuts are "not imminent"; the first future moves to 95.70. How many basis points were removed?

Key takeaways

• An OIS fixed rate equals the expected compounded overnight rate over the period; the OIS curve is the market-implied policy path.
• Futures: rate = 100 − price; one basis point = €25 or $25 on a three-month contract.
• Basis points priced for a meeting = current rate − meeting-dated rate; divide by 25 for the conventional probability.
• "50 bp of cuts priced" is a probability-weighted average, not a forecast; the surprise is the difference between the outcome and this number.

Next step

Next, we examine the limits of central bank power: independence, fiscal dominance, financial-stability tools and the banking stress of 2023.