Clues that traders are expecting new Fed policies… are we back to “bad news is good news”… what it means for the bull market
The Federal Reserve holds the market’s future in its hands.
At least, the short- to intermediate-term future.
Given this, Wall Street is analyzing everything the Fed does, trying to infer meaning and clues about future policy plans.
For months, traders have felt confident that the Fed would be staying the course with its policies. But is that confidence now crumbling?
From our technical experts, John Jagerson and Wade Hansen:
For quite a while now, traders have believed the Fed was going to keep interest rates near zero for an extended period of time and that it would maintain its current level of $120 billion of monthly bond purchases well into next year. However, traders aren’t so sure that is how it’s going to play out anymore.
Wall Street appears to be adjusting its expectations for the Fed. Some are starting to wonder if the Fed is going to announce changes at its September 22nd Federal Open Market Committee (FOMC) meeting.
In today’s Digest, let’s look at the evidence that Wall Street is adjusting its expectations. We’ll do this by peeking into John and Wade’s most recent Strategic Trader update.
If, in fact, we’re nearing the end of the ultra-dovish regime from the Fed, it sets the stage for heightened market volatility. Let’s find out what to expect.
***Are we back to “bad” news being good news?
For newer readers, John and Wade are the analysts behind Strategic Trader. This is InvestorPlace’s premier trading service. In it, John and Wade combine options, insightful technical and fundamental analysis, and market history to trade the markets in all sorts of conditions.
Before diving into today, let’s rewind to 2012-2013.
As you might recall, then-Fed Chairman Ben Bernanke was engaged in a bond-purchase program that was helping to prop up the market in the wake of the financial crisis.
The market became addicted to this stimulus. So, the release of any positive economic data that suggested the Fed may not continue its supportive policies became “bad” news.
Meanwhile, bad or disappointing economic news was “good” news, since it suggested the Fed would continue its easy-money policies.
With that “inverted world” as our example, let’s turn to John and Wade:
Last Friday, August 6, the Bureau of Labor Statistics announced that the U.S. economy had produced 943,000 new jobs during July. This was much higher than the estimated 870,000 new jobs.
It’s great news that nearly a million people found work last month, but there could be negative knock-on effects. Here’s the potential chain of events Wall Street is worried about:
- More people get jobs
- These jobs pay money
- Consumers start spending more money
- Increased demand for goods and services pushes prices higher (inflation)
- The Fed gets worried about inflation
- The Fed cuts back on Treasury and mortgage-backed securities (MBS) purchases
- The Fed raises interest rates
- Businesses and consumers borrow less as rates rise
- The U.S. economy slows down
- The stock market dips
Reminiscent of the “bad news is good news” inversion, no?
In order to examine the evidence we have that traders are, in fact, adjusting their perspectives on the Fed, let’s start with gold.
***Gold broke out of its recent wedge shape, but not in the way we wanted
On Monday, August 2, we suggested that a big move was coming for gold.
We were right… but it didn’t move in the direction we wanted.
Here’s John and Wade for what happened:
We saw gold prices fall last Friday and then flash crash on Monday.
Gold prices fell 2.4% on Friday and then plunged 4.9% in early trading on Monday before bouncing back to recover some losses (see Figure 1).
Figure 1 – Daily Chart of Gold Futures (GC)
So why the flash crash?
Traders are worried about another chain of events. This one goes as follows:
- If the Fed starts to raise rates
- Treasury yields will rise
- Treasuries will become a more attractive investment
- International investors will trade their currencies for U.S. dollars (USD) to buy more Treasuries
- Increased demand for the USD will push the value of the USD higher
- Gold prices will fall because they have an inverse relationship with the USD
John and Wade believe the gold flash crash is exaggerated, but it’s still telling. And the bottom line is that traders are nervous.
***Second, Treasury yields are moving north again
At the end of March, the yield on the 10-Year Treasury topped out at nearly 1.75%.
But then it began sliding… significantly.
Earlier this month, it fell to 1.13%.
Back to John and Wade:
After finding support at 1.13%, the 10-year Treasury Yield (TNX) has been jumping higher since last Friday (see Figure 2).
Figure 2 – Daily Chart of the 10-Year Treasury Yield (TNX)
The TNX is still nowhere close to where it was last March when inflation worries were going bananas, but it is challenging its down-trending resistance level at 1.35%. If it breaks through this level, it could easily climb back to 1.50%.
Remember, employment data is at the heart of the Fed’s decision to pare back its bond-buying program… which will be a precursor to the raising of interest rates.
So, as we get new employment data over the coming weeks, watch this chart for clues about how traders are reacting to the threat of rising rates.
***Finally, what we can learn about trader sentiment from the CME FedWatch Tool
Perhaps the purest reflection of changing Wall Street expectations can be found in the Fed Funds futures markets.
Traders drive up the price of Fed Funds futures contracts when they think the Fed is going to cut rates. Conversely, they push prices lower when they believe the Fed will raise rates.
One of the best ways to track Fed Funds futures contracts is with the CME FedWatch Tool. It shows the probabilities of an FOMC rate hike, or rate cut, that traders are pricing into the Fed Funds futures contracts.
From the Strategic Trader update:
Looking at the data in the tool for the December 14, 2022, FOMC Monetary Policy Meeting in Figure 3, you can see that traders are becoming increasingly convinced the Fed is going to raise rates by the end of 2022.
Figure 3 – CME FedWatch Tool – 14 December 2022 FOMC Monetary Policy Meeting
Here’s how you read the data:
- This data is for the 14 December 2022 FOMC Monetary Policy meeting
- The FOMC’s current Fed Funds target rate is 0-25 basis points – or 0%-0.25%
- Traders have only priced in a 34.3% chance that the FOMC is going to leave the target rate at 0-25 basis points – or 0%-0.25%– through this meeting. In other words, traders believe there is a 65.7% (100% – 34.3% = 65.7%) chance the Fed is going to raise rates by this meeting.
- One week ago – before the latest jobs numbers – traders were less confident the Fed would raise rates and were pricing in a 44.6% chance the Fed wouldn’t raise rates.
***What this means for stocks
So, Wall Street is adjusting its expectations for upcoming Fed policy.
What does this mean for stocks? Will we see a replay of 2013’s “Taper Tantrum” that roiled markets as stimulus was removed?
Here’s John and Wade to answer that, and to take us out for today:
Inflation concerns are likely here to stay.
(On Wednesday), the Bureau of Labor Statistics announced that the Consumer Price Index (CPI) rose by 5.4% during the past 12 months. This is the same amount as the June number, showing consistent pressure that the Fed is eventually going to have to respond to.
However, it’s important to keep in mind that we’re looking at the Fed raising rates at the end of 2022.
None of this means the S&P 500 has to immediately start dropping today. In fact, it’s doing the exact opposite. It’s climbing to a new all-time high (on Wednesday) (see Figure 4).
Figure 4 – Daily Chart of the S&P 500 (SPX)
We expect the bullish run in the U.S. stock market to continue for a while yet.
Have a good evening,
Jeff Remsburg
