CBOT:ZQ1!   30 Day Federal Funds Interest Rate Futures
CME: SOFR Futures ( SR31! ), E-Micro S&P 500 ( MES1! )

While football fans are fervently following the 2022 World Cup, we analogize the Federal Reserve’s year-long battle with surging inflation to a football match. In this game, the Core CPI had an early advantage over the Fed Funds Rate, at 6.00% vs. 0.25% in January. The Fed mounted decisive offense, raising rates to 4.00% and bringing the deficit down to 2 points. But make no mistake – we are still trailing in the game. The Fed would not accept defeat. With stoppage time and overtime, the fight against inflation could drag on well into 2023.

When could the Fed declare victory? Its stated goal is to keep inflation at 2%. Most of us think this is unrealistic. In my opinion, the Fed needs to bring Core CPI below the Fed Funds rate at a bare minimum.

The Fed has been known to be data-driven. Unless there is conclusive data showing the inflation is on the way down and the economy is cooling, the Fed is unlikely to end its monetary tightening policy.

The talk of Fed Pivot is very misleading. Slowing the pace of rate hikes doesn’t mean an overhaul of monetary policy. The Fed simply needs time to collect more data and evaluate if previous rate hikes are working.

A lot depends on how quickly Core CPI comes down. It peaked at 6.6% in September and lowered to 6.3% in October. But one data point doesn’t make a trend.
• In 2022, Core CPI ranges from 5.9% to 6.6%.
• In 2021, it was between 1.3% and 5.5%.
• The last time Core CPI fell below 4% was in May 2021.
• Before 2022, it was 40 years ago (August 1982) when Core CPI went above 6.0%.

In the past 1-1/2 years, Core CPI ran up very quickly and then stabilized at a very high level. Any projection of 4% Core CPI is not supported by data. I don’t see Fed would take such hypothesis into consideration.

Statistically speaking, bringing Core CPI down below Fed Funds rate could only be achieved by raising rates. The BLS will release November CPI data on December 13th, and the next FOMC meeting is scheduled on December 13th-14th. The Fed would have the most recent inflation data available in voting for its December rate decision.

Short-term: Fed Pivot Trade
Current market expectation is for the Fed to break its consecutive 75-point hikes. Any rate increase below 75 bp would give a big boost to market morale. Expect the stock market to rally, and the US dollar and bond yield to retreat.

CPI data release and Fed decision are the “one-two-punch” ideal for short-term event driven strategies. There are good candidates I like for potential trade setup, from a risk-reward standpoint:
• Call Options for CME E-Micro S&P 500 Futures (MES)
• Call Options for E-Micro NASDAQ 100 (MNQ)
• Call Options for CME Euro FX (M6E)
• Call Options for CME 30-day Fed Funds Futures (ZQ)
• Call Options for Three-Month SOFR Futures (SR3)

For a rate increase below 75 bp, stock market is expected to rally, so it is bullish for MES and MNQ. US dollar will pull back, so it is bullish for Euro/USD exchange rate.

Short-term interest rate futures are quoted as discounted instrument, 100 – Rate. Lowered expected interest rates translate into higher futures prices. Therefore, it is also bullish for ZQ and SR3.

Medium-term: Recession
The world runs on credit. Fed monetary tightening policies have made it more costly for businesses and households to obtain credit. The run-up in cost happened very quickly and the impacts are profound. Below are comparisons of interest rates between December 2021 and November 2022, taken from various sources:
• 30-year-fixed mortgage: from 3.646% to 7.296%
• 60-month auto loan rate: from 3.85% to 5.29%
• Average credit card rate: from 14.91% to 19.20%
• AAA corporate bond rate: from 2.06% to 4.64%
• BBB corporate bond rate: from 2.53% to 5.88%
• SBA loan rate: from 6%-8% to 11.5%-13.5%

Even if the Fed stops raising rates now, financing costs are not likely to return to previous levels. The unwinding of Fed policy takes time. There is no indication that the Fed would lower rates after the terminal rate is reached. More likely than not, businesses and households would bear high interest cost well into 2024.

While Core CPI excludes food and energy, their impacts are felt everywhere. Take diesel as an example, the national retail average price is $5.228/gallon on November 27th, according to the American Automobile Association (AAA).
• This is 58.8 cents (-10.1%) below its all-time high of $5.816 set on June 19th. However, it is still 69.7% higher than a year ago.
• Comparing to gasoline, at $3.555/gallon, it is $1.461 or 29.1% below its record high of $5.016. But it is a modest increase of 4.7% year over year.

Diesel price is a tax on all products requiring highway transportation. Fed rate hikes are not likely to lower diesel production cost. In addition, higher wages, higher rents, and higher borrowing cost would stick, long after the Fed stop hiking rates.

In my view, the US could not avoid a recession in 2023. Weakening corporate profit and elevated unemployment will eventually take a toll on stock prices.

We have witnessed a strong Black Friday sales season. But worrisome signs emerge that US consumers are increasingly constrained by their budget. According to a CNBC report, Walmart is the most visited shopping destination. Higher priced Bloomingdale and Nordstrom reported a lull in sales earlier this month.

The downgrade from premium department stores to discount stores is a leading indicator, a classic economic example that inferior products thrive during a recession.

Another warning sign, “Buy Now Pay Later” payments increased by 78% compared with the past week, according to the CNBC report. Consumers still want to get the great deals for holidays, but they need help with financing.

If the market rallies after the November CPI data and December FOMC decision, it’s a good time to set up a 3–6-month trade shorting the stock market. Investor sentiment has significant impacts in the short term. But fundamental factors will win over in the medium/long term. If inflation fails to decline materially, the Fed will stay on its tightening course.

Happy Trading.

*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 trade set-ups and express my market views. If you have futures in your trading portfolio, check out on CME Group data plans in TradingView that suit your trading needs www.tradingview.com/gopro/


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