“We’ve only had one thing to look at: interest rates.”
That’s how Mark Connors, head of research at investment firm 3iQ, describes the financial market’s obsession with the Federal Reserve’s historic rate-hiking campaign to fight stubborn inflation. From March 2022 to July 2023, the Fed pushed rates from nearly zero to over 5%.
“That’s a pretty dramatic hike that’s pressured the general equities market and rate-sensitive assets in particular,” adds Connors.
Following the initial hikes,U.S. equities entered a bear market, with the S&P 500 falling nearly 20% in 2022.
But with encouraging signs that inflation is ebbing, many investors expect policy makers could halt rate hikes or even unwind them in the year ahead.
The CME Group FedWatch tool, for instance, showed a 99% probability in late October that the federal funds rate would stay unchanged at 5.25% to 5.5% ahead of the Federal Open Market Committee’s November meeting.
Fed Chair Jerome Powell hinted the American economy is starting to show signs of cooling prices, though he remains watchful of upcoming data to decide if or when to end the most aggressive quantitative tightening campaign since the 1980s. The consumer price index inflation gauge showed an increase for the first time in six months in August.
“We are navigating by the stars under cloudy skies. In such circumstances, risk management considerations are critical," Powell said in his remarks at the Jackson Hole summit in August.
Foreign Exchange and Metals
Matt Tuttle, CEO of Tuttle Asset Management, said he will be monitoring how the U.S. dollar, up 3.8% against a basket of key currencies this year, performs.
“If rates come down it won’t be good for the dollar so I will be looking at precious metals and miners,” which typically move in the inverse, he explains. Indeed, a falling dollar makes the purchase of industrial metals such as aluminum, copper or silver much more feasible in multiple currencies as these are dollar-denominated markets.
CME Group copper futures prices, for example, were down more than 16% from January highs as of October 19, following rate increases in February, March and July, and the prevailing view that higher rates will be around for a while.
Gold prices spiked in the first few months of 2023, and have since leveled off. Prices for the yellow metal typically have an inverse relationship with interest rates. “With rates remaining high, and in some cases still rising, bonds and fixed income investments are an attractive alternative to gold,” Sachin Patel, Executive Director of Metals at CME Group wrote in a recent article. “But an end to the current rate hiking cycle could positively impact the gold price.”
“We are seeing that with the two and 10-year yield inversion, which is starting to flatten out but remains inverted, investors are still concerned about what the future will look like… and that uncertainty continues to bring people into gold,” said Joseph Stefans of MKS PAMP in an OpenMarkets interview in September.
Volatility in foreign exchange futures markets rose early in 2023, but fell in the summer months, according to the CME Group Volatility Index (CVOL). However, brief moves can be seen around the February, March and July FOMC meetings, where rates were increased.
Equities
The Fed’s hikes have also provided market participants with opportunities to trade the value-to-growth rotation as the “higher for longer” narrative has swung the pendulum back toward risk assets after they were pummeled last year. “The difference between the Dow and the Nasdaq has narrowed recently but they had a historically high divergence last year,” Tuttle said.
The Nasdaq, in particular, has bounced back in 2023 even as rate hikes continued. The index was up 27% through the third quarter, while the Dow Jones was up less than 2%.
As market watchers try to decipher the Fed’s next move, risk management has come to the forefront, and futures and options trading has boomed. Daily trading volume in E-mini Nasdaq-100 options at CME Group set a record in the third quarter. Total equity index options trading reached a record 1.4 million during the quarter, also a record.
Tim McCourt, Global Head of Financial and OTC Products at CME Group, says the increased options activity, particularly in weekly options, is a sign that traders see the current rate environment as one that requires close attention to managing risk.
“When we think about the impact of rates, it also impacts things like equities from a corporate earnings perspective and a dividend valuation perspective,” said McCourt. “It really comes down to the simplistic option theory that a lot of options traders are using, and it requires more active and precise risk management.”
More broadly, CME Group saw its second highest Q3 average daily trading volume ever in 2023. The total represents trading volume across interest rates, equity index, energy, agriculture, foreign exchange and metals asset classes, among others.
Energy and Agriculture
The Fed’s actions have affected asset classes differently, says Sam Stovall, chief investment strategist at broker CFRA.
“While the S&P was down 19.4% in 2022, the best performing sector was energy, mainly because of supply disruptions due to the Russia-Ukraine war,” he reveals. “Prices skyrocketed, including for consumable fuels, which soared 190%.”
If the Ukraine/Russia war continues and China’s economy firms up, energy could continue to gain, fueled by higher oil and natural gas prices, according to Stovall. Crude oil prices had remained subdued for most of the year, with higher interest rates helping to curb demand.
Following the Federal Reserve’s decision to hold rates steady in September, WTI crude oil prices fell 1%, reflecting a view that demand could decrease as a result.
Amidst the uncertain backdrop, trading volume in CME Group’s energy complex rose 16% above year ago levels in Q3, with big increases in energy options trading, which rose 42%.
Craig Erlam at forex researcher Oanda agrees energy stands to perform strongly as OPEC+ keeps a tight rein on supply. Saudi Arabia and Russia have planned supply cuts through December. Erlam also noted other commodities such as metals, agriculture and food feedstocks such as wheat could take a hit if rates stay high for a while.
Most farmers must borrow money to buy land, equipment or other inputs. For them, loans are much more costly than in 2022 when the Federal Reserve started to raise interest rates.
“One of the things you have to look at is, how do I borrow the least amount of money,” Nebraska farmer Ben Rand says.
While the risk of a U.S. and global hard landing remains, a soft landing could change the outlook sharply, analysts say.
“A soft landing could enable rates to eventually move back down,” says Erlam. “We could then see a decent rebound as economies avoid the more disastrous recessionary scenarios.”
Watching the 10-Year Note
Perhaps nowhere are the Fed’s actions felt more directly than in the Treasury market. The pivotal rate used to price mortgages and consumer loans spiked to 16-year highs in October. Powell suggested that the run-up in bond yields could mean the Fed will hold rates steady again at its November meeting.
With so many risks in play in addition to a higher rate environment, Treasury market participants have placed risk management at a premium. Treasury futures open interest – the number of unsettled futures contracts – reached a record of over 19.8 million contracts on August 23. Ultra U.S. Treasury Bond futures average daily trading volume reached a record of more than 308,000 contracts traded daily in Q3.
With the Fed holding rates steady at its September meeting, some optimism has returned. Holding rates higher could mark the beginning of a new era for Fed policy, CME Group Chief Economist Blu Putnam said in a recent video.
The very low rates of the Greenspan and Bernanke eras at the Fed “encouraged a search for yield and popularized the view that the Fed has the market’s back, artificially supporting both equities and bond prices (that is, lower bond yields),” says Putnam. “The Powell-led Fed is guiding us that those days are in the rearview mirror, and market participants are starting to agree.”
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