A “Crystal Ball” Market Tool

Understanding how the Fed Funds futures market works … the disparity between expectation and reality … connecting the “Dot” Plots … short-term pain is here

It’s been a bloodbath since Wednesday, when Federal Reserve Chairman Jay Powell disappointed bulls with hawkish rhetoric.But today, we’re going to use what’s happened as a springboard to make you a more knowledgeable investor.In their Wednesday issue of Strategic Trader, our technical experts John Jagerson and Wade Hansen walked readers through how to analyze and interpret the Fund Funds futures market and the Fed’s Dot Plot.Now, you’ll probably never trade a futures contract or need to become a Dot Plot expert. But knowing how to analyze futures and the Dot Plot will provide you powerful clues about what Wall Street traders expect for the markets.And comparing trader expectations with Fed expectations provides huge clues about where the markets could be going.After all, if the Fed and traders are on the same page, great – smooth sailing could be ahead.But if there’s a difference in expectations, well, watch out – volatility is the likely outcome, as we’ve witnessed in recent days.So, in this Friday Digest , let’s walk through how to use these tools with John and Wade’s help. You can benefit from them for years to come as you navigate the markets.

The nuts and bolts of the Fed Funds futures market

For newer Digest readers, John and Wade helm our trading newsletter, Strategic Trader.This premier trading service combines options, insightful technical and fundamental analysis, and market history to trade the markets, whether they’re up, down, or sideways.Fortunately for us, John and Wade are happy to share their arsenal of powerful indicators to provide clues about where the market is headed next…which brings us to the Fed Funds Futures market.Now, you’re likely aware that the Fed convened its December meeting on Wednesday. And you know that the market interpreted it as bearish, which has pummeled stocks ever since.But let’s dive into the mechanics of how it all came together.Here’s John and Wade to set the stage:

Fed Funds futures contracts are priced off a baseline of 100 and move up and down based on where traders believe the Federal Open Market Committee (FOMC) is going to set its target interest rate in the future.If traders believe the FOMC is going to cut rates, they push the prices of Fed Funds futures contracts higher. Conversely, if traders believe the FOMC is going to raise rates, they push the prices of Fed Funds futures contracts lower.For example, if traders believed the FOMC was going to raise its target rate from 4.50% to 5.00%, they would push the Fed Funds futures contracts down from 95.50 (100 – 4.50 = 95.50) to 95.00 (100 – 5.00 = 95.00).

With the math out of the way, let’s turn our attention to how traders were seeing the market leading into Wednesday, and the curveball the Fed threw that afternoon.

Tracking expectations with Fed Funds Futures contracts

As we’ve highlighted in the Digest, bullish sentiment gathered momentum this fall.Investors received encouraging data about weakening inflation… metrics about the health of the U.S. economy remained relatively strong… various Fed presidents began speaking in more dovish tones…Put it all together, and traders began to grow optimistic that the Fed would be less aggressive with its rate hike in December. Specifically, they only expected a 50-basis-point hike instead of 75 basis point.How do we know this?By looking at the Fed Funds futures market.Back to John and Wade:

Our favorite way to track Fed Funds futures contracts is with the CME FedWatch Tool. This tool shows you the probabilities of an FOMC rate hike, or rate cut, that traders are pricing into the Fed Funds futures contracts.For example, in the run up to today’s FOMC Monetary Policy meeting, the CME FedWatch Tool was showing that traders had priced in a 100% expectation that the FOMC would raise rates at today’s meeting. You can see this in Fig. 2.

Chart showing the CME Group's FedWatch Tool for Dece 2022
Source: CME Group

Fig. 2 – CME FedWatch Tool – Dec. 14, 2022 FOMC Monetary Policy Meeting

Here’s how you read the data…

  1. This data is for the Dec. 14, 2022 FOMC Monetary Policy meeting.
  2. The FOMC’s current target rate (before Wednesday’s meeting) is 375-400 basis points – or 3.75%-4.00%.
  3. Traders have priced in a 79.4% chance that the FOMC is going to raise the target rate 50 basis points – or 0.50% – to…
  4. 425-450 basis points – or 4.25%-4.50%.

As you know, this is exactly what happened on Wednesday. The Fed reduced the size of its rate hiking to just 50 basis points.So, if the Fed did what traders expected, why did market perform so poorly Wednesday and yesterday?Because the Fed provided new information about how high it will likely push rates in 2023. And that level is higher than where the Fed Funds futures market had previously priced it.How do we know this?

Tracking interest rates with the Fed’s Dot Plot

So, how does the Fed signal its monetary policy intentions?It publishes something called a “Dot Plot.”Back to the Strategic Trader update for more:

The FOMC releases updated economic projections at every other Monetary Policy meeting. The last time it updated its projections was at its Sept. 21, 2022, meeting.In those projections, the FOMC published its “Dot Plot” (see Fig. 4) that showed where each of the 17 members of the committee believed the target rate would be at the end of each of the next few years.

Chart showing the Fed's Dot Plot from back in September showing the terminal rate below 5%
Source: Federal Reserve Data

Fig. 4 – FOMC Dot Plot (source: Summary of Economic Projections – Sept. 21, 2022)

This “Dot Plot” showed us that…

  1. Six members of the committee thought the target rate would be at 4.75%-5.00% by the end of 2023 and that…
  2. Only seven members thought the target rate would be below 4.50% by the end of 2023.

This September Dot Plot above indicated the Fed was going to raise rates and leave them at an elevated level for a long time. But notice that the highest estimate was still below 5%.That changed on Wednesday.Below is the latest Dot Plot.As you analyze it, pay attention to two things:

  1. Expectations of interest rates being between 4.75%-5.00% at the end of 2023 are now the low end of the range of expectations with two members believing they will be at this level.
  2. All of the other members believe interest rates are going to be above 5% by the end of 2023.
Chart showing the Fed's updated Dot Plot in December showing the terminal rate below 5%
Source: Federal Reserve Data

Back to John and Wade for the takeaway:

This shows us that members of the FOMC believe interest rates are going to be much higher by the end of next year than had been priced in by Wall Street in the Federal Funds futures market.That means traders are going to have to make some adjustments to their expectations. These adjustments will likely be bearish for the stock market.

And in fact, bears have come back in force in the wake of the Fed meeting.Between the start of Federal Reserve Chairman Jerome Powell’s press conference on Wednesday and as I write early-afternoon Friday, the S&P has cratered more than 5%.

Last week in the Digest, we wrote that if the S&P couldn’t gather some bullish momentum quickly, watch out

That was based on the S&P running into the confluence of two big resistance points at once: its yearlong downward trendline and its 200-day moving average (MA).Last week, the S&P had failed to rally through this key resistance point and was falling. We wrote that bulls needed to find strength from somewhere to turn the situation around or we could be in for a steep slide.As you can see below, the situation hasn’t improved…

Chart showing the S&P riding its trendline lower all year and failing to break resistance recently
Source: StockCharts.com

Putting all this together, how do John and Wade see the immediate environment for stocks?Here’s how they concluded their update on Wednesday:

It doesn’t look like today is going to be the day that the S&P 500 breaks above its long-term down-trending resistance level.We’ll be watching to see if the index can hold above support at 3,900. 

As I write, the S&P has fallen below 3,900 and is trading at 3,830.Though the current market trend is not our friend, the two analytical tools John and Wade detailed today are. Use them throughout the rest of your investing career for helpful insights into where the markets are likely headed next.Have a good evening,Jeff Remsburg

Article printed from InvestorPlace Media, https://investorplace.com/2022/12/a-crystal-ball-market-tool/.

©2023 InvestorPlace Media, LLC