The Odds of a Rate Hike and How to Play It

Over the past few years, arguably the Federal reserve has been increasingly important in the stock market. The Fed has always been important. But its current role seems to prop the stock market up. It doesn’t do so by buying stocks but instead, the Fed uses policy tools.

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  • The Fed Is Not a Stock Market Investor

    To begin with, it is important to emphasize that the Fed does not own stocks directly.

    According to the Federal Reserve Bank of San Francisco:

    Federal Reserve System does not hold corporate stocks, but it does hold government securities. The Federal Reserve’s securities portfolio is composed of securities issued by the United States government or government agencies.

    Securities held by Federal Reserve Banks are obtained and traded through open market operations.

    While the Bank of Japan (BOJ) also conducts monetary policy through open market operations, it [does] purchase stocks from commercial banks that fit a set of specified criteria…the reason for the BOJ’s decision to purchase stocks from commercial banks:

    “The bank said falls in the Nikkei stock average…could threaten the stability of financial markets and the financial system.”

    This is the official policy of the Fed and it may conflict with popular opinion. At least some investors believe the Fed works with the Plunge Protection Team (PPT) to arrest stock market declines.

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  • According to Investopedia, “The PPT is a colloquial name given to the Working Group on Financial Markets. The PPT was originally created to provide financial and economic recommendations in the wake of turbulent market times.

    Members of the team are the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve, the Chairman of the Securities and Exchange Commission and the Chairman of the Commodity Futures Trading Commission.

    The name PPT was coined by The Washington Post in 1997. Although the team had a viable purpose when initially created, conspiracy theorists suspected that the team was created to shore up, or even manipulate, the markets.

    Some suspected that the team could executing trades on several exchanges and manipulate the markets when they were heading downward. The team was believed to collaborate only with big banks such as Goldman Sachs and Morgan Stanley, to report only to the President, and to keep no records of trades.”

    But the Fed and the PPT do not buy stocks and in fact, is not allowed to jump into the market to stop a decline under current law.

    What the Fed Does Do

    The Fed does set interest rate policy and that policy can move stock prices. The Fed can also talk about policy to move stock prices as was recently demonstrated at the end of November. Comments from Fed Chairman Jerome Powell moved the market significantly higher.

    S&P 500 index chart

    By neutral, Powell means that the Fed would not change rates for at least some time. Its current policy has been to raise rates. In October, when we were “a long way from neutral” the expectation was for significantly higher short term interest rates.

    Now that we are just below neutral, the expectation is that the Fed may not raise rates much above their current level.

    Powell’s comments also affected the outlook for interest rates. This is shown in the next chart.

    Target Rate Probabilities

    Source: CME Group

    This chart, the CME FedWatch tool, shows the probability of a rate hike and it shows in the last months, traders reduced their outlook for interest rates.

    The CME FedWatch Tool analyzes the probability of FOMC rate moves for upcoming meetings. Using 30-Day Fed Fund futures pricing data, which have long been relied upon to express the market’s views on the likelihood of changes in U.S. monetary policy, the tool visualizes both current and historical probabilities of various FOMC rate change outcomes for a given meeting date.

    Formally, “the FedWatch tool calculates unconditional probabilities of Federal Open Market Committee (FOMC) meeting outcomes to generate a binary probability tree.”

    It does that with the market prices of Fed Funds futures. So, this is not a policy tool but rather the market expectations of policy.

    Trading the Fed

    It appears the Fed may be changing its policy. If the Fed were to reverse course and begin to lower rates, it would mean they expect the economy to slow. After all, interest rates affect stocks but are primarily a tool to affect the pace of economic growth.

    In a slowing economy, investors should expect stock prices to decline. That is because sales and earnings of companies should decline as the economy slows and the stock prices should reflect the diminished prospects of growth in the companies.

    Lower rates will mean higher prices for bonds and that could be a potential profitable trading opportunity for investors. One way to trade a slowing economy could be to buy longer term bonds or ETFs that track these bonds.

    The chart of iShares 2-+ Year Treasury Bond ETF (Nasdaq: TLT) is shown below. The recent rally reflects the sharp shift in expectations that occurred among traders and analysts.

    TLT weekly stock chart

    Call options on TLT could also be a way to trade the Fed. More direct trades in short term bond funds or in money market instruments are not likely to make large moves like TLT. That’s why TLT could be the better choice for some individual investors.

    Corporate bond ETFs could be another choice. But, stocks or preferred stocks or ETFs tracking these assets could be losers as the Fed reverses course.

    Analyzing the Fed could be a useful too for investors. But many individuals discover that they are not able to complete the required amount of research because that can take an extended amount of time and they have other personal and professional commitments competing for their time.

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