Fed Pause is the New Restricted Policy
CME: Micro Russell 2000 ( 
M2K1!)
Global financial market orbits around Federal Reserve’s interest rate decisions. By concept, hiking interest rates means monetary tightening while cutting them signals easing. In reality, market perception to the Fed actions evolves over time, sometimes blurring the difference between “good news” and “bad news”.
• On May 5, 2022, the Fed surprised the market with a larger-than-expected 50-bps rate hike. The S&P 500 fell 3.6%. This is a normal market reaction to bad news.
• On July 27, 2022, the Fed hiked 75 bps and the S&P soared 2.6%! Previous meetings saw the Fed raising the stake from 25 to 50 and then 75 bps. By not getting a bigger 100-bp hike, investors were relieved and cheered as if it were good news.
• On February 1st, the Fed raised for the 8th time, but the S&P went up 1%. With lower-than expected inflation, investors concluded that this would be “the last” rate hike.
• On September 20th, the Fed paused after raising for 11 consecutive times. The S&P were down 1% as investors were spooked by the hawkish Fed statement.
Last Friday, the Bureau of Economic Analysis (BEA) reported that personal consumption expenditures price index (PIC) excluding food and energy increased 0.1% for August, lower than expectation. On a 12-month basis, the index was up 3.9%.
As the Fed’s favorite inflation gauge shows that the fight against higher prices is making progress, “Fed Pause” might be the new baseline case for the US central bank’s interest rate decision.
The futures market agrees. CME FedWatch Tool shows that the probability of the Fed keeping rate at 5.25-5.50% is high through Mid-2024. Specifically:
(Link: cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html)
• Fed pause on November 1st, 2023 FOMC meeting: an 82% probability
• Fed pause on December 13th, 2023: at 65%
• Fed pause on January 31st, 2024: at 65%
• Fed pause on March 20th, 2024: at 60%
• Fed pause on May 1st, 2024: at 49%
Last year, a Fed Pause meant slowing the rate hikes. It has a very different meaning now: to keep the interest rate higher for longer. Therefore, what was once a signal of easing should now be viewed as restricted monetary policy.
Even if the Fed stops raising rates, the cumulative effect of past rate hikes would continue to ripple through the US economy. Government policy has a lagging period, but it has passed. Households and businesses now feel the full force of higher borrowing costs. Below are two-year changes of selected interest rates from the FRED:
• 30-Year-Fixed Mortgage Rate: from 3.01% to 6.29% to 7.29%
• 72-Month New Car Loan: 4.17% - 5.19% - 7.80%
• Credit Card Interest Rate: 14.61% - 15.13% - 20.68%
• Baa Corporate Bond Yields: 3.26% - 5.97% - 6.39%
Restricted monetary policy would have negative impacts on stocks. Good news: Market prices show that investors have not yet adapted to changes in the Fed trajectory.
Russell 2000: The Weakest Link
The discounted cash flow (DCF) pricing theory states that stock price is the present value (PV) of expected future cash flows discounted by the weighted average cost of capital (WACC). A higher cost of capital shall cause stock price to fall, other things equal.
Small- and medium-sized companies would be hit harder comparing to larger corporations. As rates go up, credit standard will be tightened, and credit spread will expand. Below are current bond rates charged to companies with different credit scores:
• 10-Year Treasury Bond Yield: 4.58%
• Moody’s Aaa Corporate Bond Yield: 4.95%
• Moody’s Baa Corporate Bond Yield: 6.39%
• Bank of America BBB Corporate Bond Yield: 6.31%
• Bank of America BB High Yield: 7.55%
• Bank of America CCC or Lower High Yield: 14.05%
Russell 2000 is the benchmark stock market index for the US small companies. CME Micro Russell 2000 futures (
M2K) has a drawdown of 200 points in the past two months, from yearly high of 2013 to 1807. The index is still up 2.6% YTD.
As the Fed keeps rates high for the next 6-9 months, corporate bond yields could likely go higher. And the credit spreads, including Baa-Bbb, Baa-Bb, and Baa-Ccc, would likely get wider. This could put further downward pressure on the Russell index.
Could we quantify the impact? Let’s illustrate this with a $1 million payment, to be received in five years.
• Applying the BBB corporate bond yield 6.31% as the WACC, present value of $1 million will be $736,427.
• If the WACC goes up by 200 bps, the PV will be reduced to $670,899.
• This shows that a 2% increase in WACC could cause an 8.9% loss in market value.
The same concept would work on the Russell index. WACC could go up, either due to a rise of general interest rate level, or because of the widening of credit spread. The result would be the decrease in the market value of Russell component companies.
For someone with a bearish view of the Russell 2000, he could establish a short position in Micro Russell futures. The contract has a notional value at $5 times the index. At Friday closing price of 1807, each December contract (M2KZ3) is worth $9,035. CME Group requires an initial margin of $620 for each M2K contract, long or short.
A short trader would gain $5 for each point the M2K moving down. Hypothetically, if the Russell is 5% lower, the 90-point slide would translate into $452 gain per contract. The risk of short futures is the index going up. If investors continue to perceive Fed Pause as “good news”, Russell could rise after the November and December FOMC meetings.
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!)Global financial market orbits around Federal Reserve’s interest rate decisions. By concept, hiking interest rates means monetary tightening while cutting them signals easing. In reality, market perception to the Fed actions evolves over time, sometimes blurring the difference between “good news” and “bad news”.
• On May 5, 2022, the Fed surprised the market with a larger-than-expected 50-bps rate hike. The S&P 500 fell 3.6%. This is a normal market reaction to bad news.
• On July 27, 2022, the Fed hiked 75 bps and the S&P soared 2.6%! Previous meetings saw the Fed raising the stake from 25 to 50 and then 75 bps. By not getting a bigger 100-bp hike, investors were relieved and cheered as if it were good news.
• On February 1st, the Fed raised for the 8th time, but the S&P went up 1%. With lower-than expected inflation, investors concluded that this would be “the last” rate hike.
• On September 20th, the Fed paused after raising for 11 consecutive times. The S&P were down 1% as investors were spooked by the hawkish Fed statement.
Last Friday, the Bureau of Economic Analysis (BEA) reported that personal consumption expenditures price index (PIC) excluding food and energy increased 0.1% for August, lower than expectation. On a 12-month basis, the index was up 3.9%.
As the Fed’s favorite inflation gauge shows that the fight against higher prices is making progress, “Fed Pause” might be the new baseline case for the US central bank’s interest rate decision.
The futures market agrees. CME FedWatch Tool shows that the probability of the Fed keeping rate at 5.25-5.50% is high through Mid-2024. Specifically:
(Link: cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html)
• Fed pause on November 1st, 2023 FOMC meeting: an 82% probability
• Fed pause on December 13th, 2023: at 65%
• Fed pause on January 31st, 2024: at 65%
• Fed pause on March 20th, 2024: at 60%
• Fed pause on May 1st, 2024: at 49%
Last year, a Fed Pause meant slowing the rate hikes. It has a very different meaning now: to keep the interest rate higher for longer. Therefore, what was once a signal of easing should now be viewed as restricted monetary policy.
Even if the Fed stops raising rates, the cumulative effect of past rate hikes would continue to ripple through the US economy. Government policy has a lagging period, but it has passed. Households and businesses now feel the full force of higher borrowing costs. Below are two-year changes of selected interest rates from the FRED:
• 30-Year-Fixed Mortgage Rate: from 3.01% to 6.29% to 7.29%
• 72-Month New Car Loan: 4.17% - 5.19% - 7.80%
• Credit Card Interest Rate: 14.61% - 15.13% - 20.68%
• Baa Corporate Bond Yields: 3.26% - 5.97% - 6.39%
Restricted monetary policy would have negative impacts on stocks. Good news: Market prices show that investors have not yet adapted to changes in the Fed trajectory.
Russell 2000: The Weakest Link
The discounted cash flow (DCF) pricing theory states that stock price is the present value (PV) of expected future cash flows discounted by the weighted average cost of capital (WACC). A higher cost of capital shall cause stock price to fall, other things equal.
Small- and medium-sized companies would be hit harder comparing to larger corporations. As rates go up, credit standard will be tightened, and credit spread will expand. Below are current bond rates charged to companies with different credit scores:
• 10-Year Treasury Bond Yield: 4.58%
• Moody’s Aaa Corporate Bond Yield: 4.95%
• Moody’s Baa Corporate Bond Yield: 6.39%
• Bank of America BBB Corporate Bond Yield: 6.31%
• Bank of America BB High Yield: 7.55%
• Bank of America CCC or Lower High Yield: 14.05%
Russell 2000 is the benchmark stock market index for the US small companies. CME Micro Russell 2000 futures (
M2K) has a drawdown of 200 points in the past two months, from yearly high of 2013 to 1807. The index is still up 2.6% YTD.As the Fed keeps rates high for the next 6-9 months, corporate bond yields could likely go higher. And the credit spreads, including Baa-Bbb, Baa-Bb, and Baa-Ccc, would likely get wider. This could put further downward pressure on the Russell index.
Could we quantify the impact? Let’s illustrate this with a $1 million payment, to be received in five years.
• Applying the BBB corporate bond yield 6.31% as the WACC, present value of $1 million will be $736,427.
• If the WACC goes up by 200 bps, the PV will be reduced to $670,899.
• This shows that a 2% increase in WACC could cause an 8.9% loss in market value.
The same concept would work on the Russell index. WACC could go up, either due to a rise of general interest rate level, or because of the widening of credit spread. The result would be the decrease in the market value of Russell component companies.
For someone with a bearish view of the Russell 2000, he could establish a short position in Micro Russell futures. The contract has a notional value at $5 times the index. At Friday closing price of 1807, each December contract (M2KZ3) is worth $9,035. CME Group requires an initial margin of $620 for each M2K contract, long or short.
A short trader would gain $5 for each point the M2K moving down. Hypothetically, if the Russell is 5% lower, the 90-point slide would translate into $452 gain per contract. The risk of short futures is the index going up. If investors continue to perceive Fed Pause as “good news”, Russell could rise after the November and December FOMC meetings.
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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