Tech rises then falls based on the FOMC meeting … evaluating the odds of a rate hike … tools you can use to help plan your market approach

On Wednesday, the Federal Open Market Committee (FOMC) performed a “walk-the-line” that resulted in markets climbing in the afternoon.

As a short recap, the central bank upgraded its 2021 GDP growth forecast to 6.5% (for context, that would be the largest annual output since 1984). It also said it expects unemployment to drop to 4.5% by the end of the year; the previous estimate was 5%.

Most importantly, Fed Chair Jerome Powell said that inflation is forecasted to reach 2.4% in 2021, above its previous estimate of 1.8%. But Powell said this would be a temporary surge.

In light of the anticipated brevity of inflation, the Fed largely maintained a “stay the course” plan, meaning they expect to keep rates close to 0% until 2024.

As previously noted, the markets initially seemed okay with this, resulting in a Wednesday afternoon rally.

But, as often happens, traders digested the news overnight and sentiment changed.

Yesterday, the yield on the 10-Year Treasury (a critical metric relating to inflation) jumped to 1.75% as inflation-fears set back in. This led to another tech selloff, with the Nasdaq dropping 3%.

As I write Friday morning, tech is trying to recover, with the Nasdaq up almost half a percent.

Now, let’s step back a moment.

What we’ve just covered is the broad takeaway of the FOMC meeting and its impact on the markets. But there are finer details here that can add additional color.

Today, we’re going to dive into these details with the help of our technical experts from Strategic Trader, John Jagerson and Wade Hansen.

This will give you a richer understanding of these FOMC meetings, as well as how to interpret them in the future.

Plus, you’re going to learn a little trick that traders use involving futures contracts. As John and Wade write, “you may never trade a futures contract in your life, but learning how to watch the futures market for clues about what traders are expecting in the future will make you a better stock and options trader.”

Lots to cover, so let’s jump in.

 

***An intro to Fed Funds futures

For newer Digest readers, John and Wade are the experts behind Strategic Trader. It’s an options service in which they combine insightful technical and fundamental analysis, with market history, to take advantage of all sorts of market conditions.

In their update from Wednesday, John and Wade point out that too many stock and options traders believe they only need to pay attention to the stock market. However, there is so much we can learn from other financial markets that can help your portfolio.

In this case, John and Wade are talking about Fed Funds futures.

From their update:

Fed Funds futures contracts are priced off a baseline of 100 and move up and down based on where traders believe the 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.

Some newer investors get a little confused on this interplay between prices and yields. Why, exactly, do traders respond as they do?

Say you have a bond priced at $1,000 that has a coupon rate of 5%.

Now, imagine that a year later, market rates have climbed to 6%. This means that new bond issuances are offering 6%, yet they’re still priced at the same $1,000.

Why would any investor buy that old 5% bond when a new bond yields 6% for the same money?

They wouldn’t.

So, what happens is the price of that old 5% bond will fall. It will sell at a discount to its original $1,000 price tag to be competitive with the new 6% bonds. This will make each bond’s total yield to maturity more similar.

In this case, perhaps that 5% bond now costs only, call it, $950 whereas the 6% bond costs $1,000.

There’s a similar dynamic when it comes to the FOMC and its Fed Funds rate.

For example, if traders think the Fed is going to raise its target rate, they’re going to push the price of Fed Funds futures contracts down. Conversely, if traders expect a rate cut, they’ll push futures contracts prices up.

Back to John and Wade now for what’s happening in the economy, and what that means for rates:

Wall Street is now starting to wonder if this new landscape is one that is going to include increased inflationary pressure and a sooner-than-expected increase in the FOMC’s target rate, which could put the brakes on the S&P 500’s current run.

We know Wall Street is wondering because traders are starting to make moves in the Fed Funds futures market.

How exactly do John and Wade know this?

By evaluating a tool which you can check out yourself.

 

***How you can track moves in the Fed Funds futures market

John’s and Wade’s favorite way to track Fed Funds futures contracts is with the CME FedWatch Tool.

It shows you the probabilities of an FOMC rate hike (or cut) that traders are pricing into the Fed Funds futures contracts.

Back to John and Wade for an example:

… in the run up to (Wednesday’s) FOMC Monetary Policy meeting, the CME FedWatch Tool was showing that traders had priced in a 100% expectation that the FOMC would not raise rates at the meeting. You can see this in Fig. 1.

 

Fig. 1 — CME FedWatch Tool — March 17, 2021 FOMC Monetary Policy Meeting

 

Here’s how you read the data:

1. This data is for the March 17, 2021 FOMC Monetary Policy meeting

2. The FOMC’s current target rate (before the meeting) is 0-25 basis points, or 0%-0.25%

3. Traders have priced in a 100% chance that the FOMC is going to leave the target rate at …

4. 0-25 basis points, or 0%-0.25%

This is how the chart for each FOMC monetary policy meeting in 2021 — which fall on April 28, June 16, Sept. 22, Nov. 3 and Dec. 15 (see the tabs across the top of the tool) — looked at the beginning of the year.

Nobody was pricing in a chance of a rate hike.

However, as inflationary concerns have picked up, expectations have started to change, and those changes are showing up in the CME FedWatch Tool.

If you look at the chart for the Dec. 15 meeting in Fig. 2, you can see the differences.

 

Fig. 2 — CME FedWatch Tool — Dec. 15 2021 FOMC Monetary Policy Meeting

Now, what’s interesting is how quickly these projections can change … which reflects how traders are feeling in real-time.

To illustrate, in John’s and Wade’s update above, the percentage of traders pricing in a quarter-point rate hike in December is 4.2% (it’s small font, so I doubt you can read it).

Here we are on Friday, just two days later, and this percentage has more than tripled from 4.2% to 13.6% as I’ll show you below.

And there’s an additional twist …

Some traders are now even pricing in a half-point rate hike — not just a quarter-point. Granted, it’s a small number of traders — just 0.7% – but it reflects how outlooks shift rapidly.

Back to John and Wade:

(Traders) are worried because they know that rising interest rates have the potential to curb stock growth and potentially lead to a selloff in the stock market.

That’s why (Wednesday’s) FOMC monetary policy meeting was so important. Everyone was waiting to see if the FOMC was going to signal an earlier-than-expected rate hike.

 

***How you can watch for rate-hike signals

At this point in their update, John and Wade offer another tool for investors — the Fed’s Dot Plot.

In short, the Fed “Dot Plot” shows projections from each of the 17 committee members, reflecting where they believe the target rate will be at the end of each of the next few years.

Below, we see the Dot Plot from last December, followed by commentary from John and Wade.

Fig. 3 — FOMC Dot Plot (Source: Summary of Economic Projections — Dec. 16 2020

 

This Dot Plot showed us that …

1. Only one member of the committee thought the target rate would be increased above the current rate of 0%-0.25% by the end of 2022 and that …

2. Only five members thought the target rate would be increased above the current rate of 0%-0.25% by the end of 2023.

That was an incredibly strong indication that the FOMC was going to leave rates low for a long time. Wall Street loved this because low interest rates usually mean stronger economic growth and higher stock prices.

This past Wednesday’s Dot Plot painted a slightly changed picture.

Three more members of the FOMC than last time believe rates are going to rise by the end of 2022, and two more members believe rates are going to rise by the end of 2023.

Back to the update for perspective:

This shows that there is a slight increase in concern among FOMC members that they may need to raise interest rates to combat potential inflation, but that concern seems to be muted.

Putting everything together, here’s John’s and Wade’s bottom line:

We don’t think Wall Street is going to be too worried that the FOMC is going to restrict future economic growth by raising interest rates too far, too soon.

This should free traders up to continue buying and pushing stock prices higher.

Going forward, check out the CME FedWatch tool, and keep an eye on the updated Dot Plots. They’ll provide you valuable information as you chart the course for your own portfolio.

For now, though tech is still adjusting to the possibility of higher rates, the overall market appears to be handling it in stride. We’ll keep you up to speed here in the Digest.

Have a good evening,

Jeff Remsburg