Gambling with Martin Place

Reskewing the cash rate forecast

The ASX publishes daily updates for financial market’s best guess as to what the cash rate will be over the coming months. These forecasts are derived from the 30 day futures market in which financial markets traders try to accurately predict what the RBA will do at their meeting next week and in the months to come.

Current the forecasts imply that the market expectation is for the RBA cash rate to increase by an average of 40bp in September. But this only tells us what the average forecast outcome is. It is unable to tell us how much uncertainty there is around this forecast.

Does the market expect that the RBA will increase the cash rate by 40bp with 100% probability? This would be consist with the current futures market forecast.

Or does it expect that there is a 60% chance of a 50bp increase and a 40bp chance of a 25bp increase? This would also imply an average increase of 40bp in September.

Or perhaps some combination of the two: a 20% chance of 25bp, 50% chance of 40bp and a 30% chance of 50bp which also gives you an expected mean increase of 40bp.

Unfortunately (to my knowledge) Australia doesn’t have the sort of cash rate options market which allows for price discovery about the higher moments of the future cash rate which would allow us to select between all of these potential forecasts.

Enter the Bookies

However there are some less conventional markets that do offer a slightly more nuanced set of forecasts. Betfair allows punters to bet on (or against) three potential outcomes: a 25bp decrease, no change, a 25bp increase or any other result.

While the first two outcomes are highly unlikely, let’s assume a zero probability, we can use the offered odds from Betfair to calculate the probability of a 25bp increase in order to back out the markets probability distribution of the cash rate after next Tuesday.

Current odds of ~7.4 imply that there is a roughly 13.5% chance that the RBA increases the cash rate by 25bp. If we assume that the only other alternatives are a target-rounding 40bp or another round of 50bp we get the following probabilities which are consist with by the cash rate futures market and Betfair’s odds:

25bp = 13.5%

40bp = 66.1%

50bp = 20.3%

The combination of the markets forecast of an average 40bp increase and Betfair’s very high likelihood (>85%) that the cash rate will change by more than 25bp implies that there is a very good chance the RBA will decide to return the cash rate target to the round number of 2.25%.

We could also re-calculate these numbers including for the potential of a 75bp increase in the cash rate - but this stretches the numbers past breaking point. The only way to make it work is if there is a 6% chance of 75bp and a ~0% chance of 50bp which doesn’t make sense.

This strong forecast of a 40bp rise seems a little too high in my humble opinion, but who am I to question the wisdom of the market. I guess we will find out next Tuesday afternoon!

PS In the time since I wrote this post it looks like the cash rate futures may have increased somewhat so perhaps the market has settled on another round of 50bp increases.