Cracking the Fed Rate-Setting Code
CME: Micro Russell 2000 ( 
M2K1!)
On August 25th, Federal Reserve Chair Jerome Powell delivered his annual policy remark, “Inflation: Progress and the Path Ahead”, at the Jackson Hole Symposium.
The message is very clear: It is the Fed's job to bring inflation down to the 2% policy goal. The Fed is prepared to raise rates further if appropriate and intends to hold policy at a restrictive level until inflation is moving sustainably down toward its objective.
In my opinion, there is a constraint when the Fed considers its policy choices. If monetary tightening pushes the US economy into a recession, it will likely pause or pivot. The Fed aims to cool the economy, not to put the flame out.
The Fed Chair maintains that he iterates his decision at each FOMC meeting based on latest available data. I liken this process to a “For Loop” and an “If Statement” in computer programming. Below is my pseudo code in human readable form:
• for (i = 0; i < n; n++), where n is the number of FOMC meetings;
• if (inflation goes down to 2%), then execute “End Rate Hikes”;
• else if (the US economy tanks), also execute “End Rate Hikes”;
• else, execute “Continue with Restrictive Monetary Policy”);
In other words, the only two conditions that could trigger the end of rate hikes are:
• Rate hikes successfully bring the inflation down to 2%; or
• Rate hikes break the US economy.
To crack the code of the Fed rate-setting decisions, we need to gain some understanding of the US inflation trajectory and the economic growth potential.
Inflation Outlook: Coming Down but Still Too High
According to the Bureau of Labor Statistics (BLS), the US Consumer Price Index rose 0.2% in July to 3.2% on an annualized basis.
• CPI peaked at 9.1% in June 2022. The declining inflation in the past year is a welcome development and signals that the Fed tightening policy is working;
• The key driver of low CPI reading is the double-digit decline in energy cost when compared to the record gasoline price last year. This is misleading and lagging data. Gasoline and diesel prices are both on the way up for months;
• The Core CPI, excluding energy and food, is 4.7%. Compared to 5.9% in July 2022, the decline is not fast enough, and it is still too high;
• At 7.7%, Shelter leads all categories and has the highest price increases. Higher interest rates pushed up mortgage payments and rents. This could lift overall inflation higher in the coming months.
The Fed’s preferred inflation metric is the PCE price index. According to the Bureau of Economic Analysis (BEA), PCE price index for June increased 3.0% on an annualized basis. Excluding food and energy, the core PCE increased 4.1% from one year ago.
The BEA is scheduled to release July PCE data this week. The new reading would influence the Fed as it debates whether to pause or continue raising rates in the September 20th FOMC meeting.
US Economic Outlook: Very Resilient
According to the BEA, US real gross domestic product (GDP) increased at an annual rate of 2.4% in the second quarter of 2023. In the first quarter, real GDP increased 2.0%.
• Current‑dollar GDP increased 4.7% at an annual rate, or $305.2 billion, in the second quarter to a level of $26.84 trillion;
• After the US central bank aggressively raised interest rates from 0.25% to 5.50% in a year and a half, the US economy shows remarkable strength.
According to the BLS, total nonfarm payroll employment rose by 187,000 in July, and US the unemployment rate changed little at 3.5%. Job gains occurred in health care, social assistance, financial activities, and wholesale trade.
As long as unemployment remains low, American consumers would continue to buy goods and services, pay their bills, and service their debts.
• US mortgage delinquency rate was 1.72% in Q2, the lowest in 17 years (vs. 1.74% in Q3 2006), according to the Federal Reserve Bank of St. Louis;
• Auto loan delinquency rates have risen from Q1 2021's 1.43% to 1.69% in Q1 2023, according to a recent Credit Industry Insight Report (CIIR) by TransUnion.
• US credit card loan delinquency rate was 2.77% in Q2, up from 2.43% in Q1 and 1.59% from year-ago quarter;
Why are we seeing different trends? I think that most homeowners locked into low 15- or 30-year fixed mortgage rates before the Fed rate hikes.
Auto loans have shorter duration, usually between 4 to 7 years. Since last year, car buyers now were hit by both higher prices and higher interest rates.
Credit card default is elevated, but still low from a historical perspective. In the 1990s and early 2000s, delinquency rates hovered around 3-5%. It peaked at 6.77% in 2009 after the financial crisis. Credit card companies charge floating interest rates. In January 2022, before the rate hikes, interest rates averaged around 16%. They are now above 24%.
My takeaways
Overall, my assessment is that US inflation is not likely to go down to 2% by 2024. While consumers are under stress, it’s not enough to push the US economy into a recession.
Therefore, I believe that the Fed would keep higher interest rates for a longer period. At each meeting, it would iterate whether to raise or to pause, but not to cut rates.
Impacts to US Stock Market Valuation
Up to now, investors were obsessed with the unrealistic assumptions of Fed cutting rates three to four times in 2024. The Jackson Hole speech is a wake-up call. Stock market valuation will have to be repriced based on new long-term interest rate assumptions.
Higher interest rates raise the cost of capital for all US corporations. Using the Discounted Cash Flow (DCF) stock valuation method, a company’s present value will decline as a higher rate discounts all future cash flows by a greater percentage.
The S&P 500 index has gained 14.75% year-to-date. In recent weeks, it has retreated 200 points (-4.4%) from its 52-week high. The prospect of higher long-term interest rates could put further pressure on the Blue-chip US stock market index.
The Nasdaq composite index has gained 29.85% year-to-date. It has a drawdown of 850 points (-5.9%) from its 52-week high. Even a blowout quarterly profit from chip giant Nvidia failed to lift the leading technology stock index higher last week.
Trade Ideas
On August 11th, 2022, I published a trade idea, “A Tale of Two Americas”. In assessing the impact of Fed rate hikes, I concluded that smaller companies would be hit harder than their larger counterparts. I explored the idea of shorting the lofty valued Russell 2000.
At the time, the Russell was quoted at 1,974 and had a trailing Price/Earnings Ratio of 68.96. Fast-forwarding to August 25th, Russell was settled at 1,853 (-6.1%) and the P/E has collapsed to just 27.61, according to Birinyi Associates and Dow Jones Market Data.
Today, I still favor the idea of shorting the CME Micro Russell 2000 (
M2K). Why?
A year ago, the US Corporate BBB Effective Yield was 5.04%. It rose 112 basis points to 6.16% last week, according to Fed data.
After the Jackson Hole speech, I expect the bond yield to move up with the new assessment of higher long-term interest rate. Therefore, Russell 2000 would face further downward pressure.
The March Rusell 2000 contract (M2KH4) was settled at 1,888 last Friday. Each contract is $5 x Index and has a notional value of $9,440 at current market price. CME requires an initial margin of $620.
While shorting a futures contract, an investor could consider setting a stop loss. Hypothetically, a stop loss at 1,800 would limit the loss to $440 (= (1888-1800) * 5).
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
M2K1!)On August 25th, Federal Reserve Chair Jerome Powell delivered his annual policy remark, “Inflation: Progress and the Path Ahead”, at the Jackson Hole Symposium.
The message is very clear: It is the Fed's job to bring inflation down to the 2% policy goal. The Fed is prepared to raise rates further if appropriate and intends to hold policy at a restrictive level until inflation is moving sustainably down toward its objective.
In my opinion, there is a constraint when the Fed considers its policy choices. If monetary tightening pushes the US economy into a recession, it will likely pause or pivot. The Fed aims to cool the economy, not to put the flame out.
The Fed Chair maintains that he iterates his decision at each FOMC meeting based on latest available data. I liken this process to a “For Loop” and an “If Statement” in computer programming. Below is my pseudo code in human readable form:
• for (i = 0; i < n; n++), where n is the number of FOMC meetings;
• if (inflation goes down to 2%), then execute “End Rate Hikes”;
• else if (the US economy tanks), also execute “End Rate Hikes”;
• else, execute “Continue with Restrictive Monetary Policy”);
In other words, the only two conditions that could trigger the end of rate hikes are:
• Rate hikes successfully bring the inflation down to 2%; or
• Rate hikes break the US economy.
To crack the code of the Fed rate-setting decisions, we need to gain some understanding of the US inflation trajectory and the economic growth potential.
Inflation Outlook: Coming Down but Still Too High
According to the Bureau of Labor Statistics (BLS), the US Consumer Price Index rose 0.2% in July to 3.2% on an annualized basis.
• CPI peaked at 9.1% in June 2022. The declining inflation in the past year is a welcome development and signals that the Fed tightening policy is working;
• The key driver of low CPI reading is the double-digit decline in energy cost when compared to the record gasoline price last year. This is misleading and lagging data. Gasoline and diesel prices are both on the way up for months;
• The Core CPI, excluding energy and food, is 4.7%. Compared to 5.9% in July 2022, the decline is not fast enough, and it is still too high;
• At 7.7%, Shelter leads all categories and has the highest price increases. Higher interest rates pushed up mortgage payments and rents. This could lift overall inflation higher in the coming months.
The Fed’s preferred inflation metric is the PCE price index. According to the Bureau of Economic Analysis (BEA), PCE price index for June increased 3.0% on an annualized basis. Excluding food and energy, the core PCE increased 4.1% from one year ago.
The BEA is scheduled to release July PCE data this week. The new reading would influence the Fed as it debates whether to pause or continue raising rates in the September 20th FOMC meeting.
US Economic Outlook: Very Resilient
According to the BEA, US real gross domestic product (GDP) increased at an annual rate of 2.4% in the second quarter of 2023. In the first quarter, real GDP increased 2.0%.
• Current‑dollar GDP increased 4.7% at an annual rate, or $305.2 billion, in the second quarter to a level of $26.84 trillion;
• After the US central bank aggressively raised interest rates from 0.25% to 5.50% in a year and a half, the US economy shows remarkable strength.
According to the BLS, total nonfarm payroll employment rose by 187,000 in July, and US the unemployment rate changed little at 3.5%. Job gains occurred in health care, social assistance, financial activities, and wholesale trade.
As long as unemployment remains low, American consumers would continue to buy goods and services, pay their bills, and service their debts.
• US mortgage delinquency rate was 1.72% in Q2, the lowest in 17 years (vs. 1.74% in Q3 2006), according to the Federal Reserve Bank of St. Louis;
• Auto loan delinquency rates have risen from Q1 2021's 1.43% to 1.69% in Q1 2023, according to a recent Credit Industry Insight Report (CIIR) by TransUnion.
• US credit card loan delinquency rate was 2.77% in Q2, up from 2.43% in Q1 and 1.59% from year-ago quarter;
Why are we seeing different trends? I think that most homeowners locked into low 15- or 30-year fixed mortgage rates before the Fed rate hikes.
Auto loans have shorter duration, usually between 4 to 7 years. Since last year, car buyers now were hit by both higher prices and higher interest rates.
Credit card default is elevated, but still low from a historical perspective. In the 1990s and early 2000s, delinquency rates hovered around 3-5%. It peaked at 6.77% in 2009 after the financial crisis. Credit card companies charge floating interest rates. In January 2022, before the rate hikes, interest rates averaged around 16%. They are now above 24%.
My takeaways
Overall, my assessment is that US inflation is not likely to go down to 2% by 2024. While consumers are under stress, it’s not enough to push the US economy into a recession.
Therefore, I believe that the Fed would keep higher interest rates for a longer period. At each meeting, it would iterate whether to raise or to pause, but not to cut rates.
Impacts to US Stock Market Valuation
Up to now, investors were obsessed with the unrealistic assumptions of Fed cutting rates three to four times in 2024. The Jackson Hole speech is a wake-up call. Stock market valuation will have to be repriced based on new long-term interest rate assumptions.
Higher interest rates raise the cost of capital for all US corporations. Using the Discounted Cash Flow (DCF) stock valuation method, a company’s present value will decline as a higher rate discounts all future cash flows by a greater percentage.
The S&P 500 index has gained 14.75% year-to-date. In recent weeks, it has retreated 200 points (-4.4%) from its 52-week high. The prospect of higher long-term interest rates could put further pressure on the Blue-chip US stock market index.
The Nasdaq composite index has gained 29.85% year-to-date. It has a drawdown of 850 points (-5.9%) from its 52-week high. Even a blowout quarterly profit from chip giant Nvidia failed to lift the leading technology stock index higher last week.
Trade Ideas
On August 11th, 2022, I published a trade idea, “A Tale of Two Americas”. In assessing the impact of Fed rate hikes, I concluded that smaller companies would be hit harder than their larger counterparts. I explored the idea of shorting the lofty valued Russell 2000.
At the time, the Russell was quoted at 1,974 and had a trailing Price/Earnings Ratio of 68.96. Fast-forwarding to August 25th, Russell was settled at 1,853 (-6.1%) and the P/E has collapsed to just 27.61, according to Birinyi Associates and Dow Jones Market Data.
Today, I still favor the idea of shorting the CME Micro Russell 2000 (
M2K). Why?A year ago, the US Corporate BBB Effective Yield was 5.04%. It rose 112 basis points to 6.16% last week, according to Fed data.
After the Jackson Hole speech, I expect the bond yield to move up with the new assessment of higher long-term interest rate. Therefore, Russell 2000 would face further downward pressure.
The March Rusell 2000 contract (M2KH4) was settled at 1,888 last Friday. Each contract is $5 x Index and has a notional value of $9,440 at current market price. CME requires an initial margin of $620.
While shorting a futures contract, an investor could consider setting a stop loss. Hypothetically, a stop loss at 1,800 would limit the loss to $440 (= (1888-1800) * 5).
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
Jim W. Huang, CFA
jimwenhuang@gmail.com
jimwenhuang@gmail.com
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