In Economics 101, we were taught that the U.S. Federal Reserve Bank (the “Fed”) conducts monetary policy through open market operations. These open market operations – the buying and selling of government securities – are how the Fed ultimately controls the federal funds interest rate. Why is this rate so important? Because it is one of the Federal Reserve’s primary tools for preventing inflation from running rampant and controlling the peaks and troughs of a business cycle. With the current target rate for federal funds at 0–0.25%, the next time the Federal Open Market Committee changes its longstanding policy of low interest rates and finally decides on an increase is being highly anticipated. Through the federal funds futures contract, we can see the market’s estimate of the probability of a change in the target federal funds rate.
The federal funds futures contract was introduced by the Chicago Board of Trade in October 1988. This product enables individuals and businesses to hedge increases and decreases in short-term interest rates. Each federal funds futures contract represents the average overnight federal funds rate for the contract month. This means that as the days in the current contract month pass, the more closely the futures price will represent the actual average federal funds rate for the month.
Although the FOMC has taken abnormal measures in keeping the target federal funds rate at 0-0.25% for more than two years running, there is no doubt that it will have to reverse course and start to increase rates eventually. If the U.S. economy continues to create jobs and economic growth returns to normal, the Fed will have no choice but to start increasing rates. With the use of the federal funds futures contract, we can be better informed and hopefully anticipate this rise. Understanding and anticipating the Federal Reserve’s moves may help you determine the direction of short-term interest rates.
So how does all this fit in with the current market historically? Interest rates are normally thought of as a negative to stock prices. The additonal costs of borrowing money at higher rates for their operations is an additional weight on profit. Usually less profit equates to lower stock prices. The fact that interest rates have been held down by the Fed for some time now, artificially with QE2, may have the markets responding to any rate increase with more fervor that otherwise.
Should any rise in rates be attributed to increased economic activity it should be a positive to stock prices, but any rise in rates widely thought of as a preventative inflation measure will be a negative.
In a prior article last week the case for the current pullback just being a correction was advanced. Normally in a upward trending market a small pullback occurs at resistance areas such as the one it reversed from. We know it has to come up to the prior high to go on to new highs by definition, but these prior highs and pivots represent some potential danger. So far this analysis looks to be the case as the market climbs back up from the corrections bottom.
The ‘sell in May and go away’ battle cry may be misleading if we see the highs again at the end of the month. (It was not correct last year.) With all the global financial and geopolitical problems we have apparently been watching teflon markets.
Timing is everything in trading and this is why it is so important to be able to analyze the quality of a pullback, and determine the probability of a further fall or not; especially as we near the prior post crash highs and especially in this economic and political environment. You can always search the internet for someone like me who may be writing about it and hope (there’s that word again), that they are right or learn to analyze it yourself. It is really not that hard. The prior article is included on the page link at the bottom of this article on how to do this along with other articles on how to trade professionally with a trading plan.
Thinking of only the bullish case for the future should stock prices reach the 2008 post crash highs we can find some historic examples. Since 1950 we have only seen two other occurrences of a double top pattern as both happened in the late 1960’s and early 1970’s. Both of these events were followed by sizeable drops (points A to B in the chart), of -50% and -35%. You may also notice both exhibited an “abc” type corrective rally from their previous lows which look very similar to what is occurring right now in the market since the March 2009 low.
If you look at the period from 1900 through 1949 there was one other double top pattern which met similar conditions as described above in the early 1900’s which was also followed by a 38% correction; and there is a case in the mid 1940’s where a double top was close to being formed, and that as well was followed by a 30% correction. You will see a similar “abc” type pattern in both of them as well.
Technically the stock market has some tough ground to get through before a challenge of the post crash highs can be made, but the trend is up. Fundamentally, as you can read in the news every day there are many obstacles raising reasonable doubts as well:
The debt ceiling could be raised; Congress could reach a long-term deficit reduction compromise; Europe could prevent a Greek debt restructuring; China could get its soft landing planning just right; commodity prices, and namely gasoline, could come down in price; conflict in the MENA region could be resolved; and the labor market recovery in the U.S. could pick up steam as the housing and mortgage problem abates. Well, that’s a lot of ‘coulds’. The fact is there are headwinds against the market, any of which by itself could derail things. (Another could).
What has held stock prices up is most company’s ability to weather all these storms and post very good earnings for at least the time being. The back half of earnings season we are closing out of has not been as good as the first half, and the market seems to have taken strong note.
In the last few days the dollar has again shown some strength and that has also creating the selling that sparked this correction. Traders are fearful that commodities are entering a longer correction period. The business media has been reporting on the dollar and the commodity trade for weeks now. The lower dollar/higher market, and higher dollar/lower market still seems to be the connection. Just a small rise in the dollar has set of a huge sell off in the commodities of silver, gold and oil. Many traders connect this to the slow down in China, and the European debt problems.
The underlying action in stocks to this dollar/commodity connection was extraordinary. It would have been reasonable to assume that other areas of the equity market would hold up relatively well as commodity prices tanked. After all, lower commodity prices are a good thing for consumers and for profit margins for most companies just like interest rates. But this would not be the proper deduction after watching equities fall too. This last week the teflon nature of this market asserted itself somewhat when the PPI was up .8% (core +.3%), and retail sales were also up .5%. Initial claims for job losses were down 44K but this was below expectations. This morning the CPI came out at a .4% increase. The PPI and CPI have steadily been on the rise, but you already know this if you buy food or gasoline.
This and volatility is playing a big part in daily price action and making trend trading difficult. Patterns that usually produce reliable follow through are failing more often. High frequency trading has not helped this as the stop losses needed to produce winning trades often need to be quiet large, making risk to rewards larger and bigger losses when set trades fail. This is definitely an environment that great care must be taken. While we saw the dollar rise this week the longer term trend is down, and the longer term trend for commodities is up. For now we still have the longer term trend on the stock market up as well.
Link to Article
Trade with a plan.
(Enter “LUCKY305” for a 25% discount)