Fed Policy Trajectory and Interest Rate Outlook
CBOT: Micro 2-Year Yield ( 
2YY1!), Micro 10-Year Yield ( 
10Y1!) and Micro 30-Year Yield ( 
30Y1!)
The latest US jobs report showed that employers added 216,000 jobs for December while the unemployment rate held at 3.7%, reported by the Bureau of Labor Statistics (BLS). That compared with respective market estimates of 170,000 and 3.8%.
On Thursday, the BLS will release December’s CPI data. The prevailing market expectation is 0.3% monthly increase for headline CPI, up from 0.1% in November.
The Federal Reserve sets monetary policy to support price stability and full employment. New data shows that the US economy is very resilient, and maybe slightly overheated with the upbeat job market.
After hiking interest rates 11 times and pausing for 2 times, the Fed now has a dilemma. “To cut, or Not to cut”, this is a trillion-dollar question.
In this 3rd installment of new year outlook for major asset classes, I will discuss what opportunities may lie ahead for bonds and interest rate derivatives.
FYI: The first writing was a year-end review for metal commodities – Gold, Copper, and Aluminum. If you haven’t read it yet, you may follow the link here:
https://www.tradingview.com/i/Lnm0zHT0/
The second writing was New Year outlook for US equities – the benchmark market indexes Dow, S&P 500 and Nasdaq 100.
https://www.tradingview.com/chart/SPX/XjHpsvvS-US-Equities-2024-Outlook/
2023: what’s the dominating market narrative?
Last year, the Fed raised interest rates four times for a total of 100 bps. This was a slower pace comparing to the year before, where we saw seven rates hikes and 400 bps in total.
To the surprise of most analysts, businesses continue to expand and hire new workers under tightened credit. Inflation could creep up with higher wages and a strong job market.
US stock market rose for most of the year, shaking off bad news along the way. Despite interest rates are 5% higher than two yeas ago, major market indexes reached all-time-high records last December. The S&P 500 gained 23.9% for the year, and the Nasdaq Composite more than doubled that at 53.9%.
2024 Outlook for US Interest Rates
Most investors agree that the Fed will cut rates in 2024. But the expectations for the timing and scope vary significantly.
According to CME Group’s FedWatch Tool, the first rate-cut could occur at the March 20th Fed meeting, with a 69.2% probability. For June 12th, the odds of two or more rate cuts increase to 85.9%. By December 18th, investors expect the Fed Funds rate to fall between 1% to 2% lower than the current 5.25-5.50% range, with a 97.9% odds (Data as of January 7th).
(Link: cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html)
Treasury prices and yields move in opposite directions. Current bond prices reflect the market expectations of 5-8 rate cuts in 2024. Lower yields, higher prices.
The January 2nd CFTC Commitments of Traders report (COT) shows that “Leveraged Funds” hold the following open positions on CBOT interest rate futures:
• Fed Funds: 224,772 longs and 489,204 shorts
• 2Y Treasury: 775,882 longs and 2,266,563 shorts
• 5Y Treasury: 844,600 longs and 2,821,682 shorts
• 10Y Treasury: 285,598 longs and 775,882 shorts
• 30Y Treasury: 79,124 longs and 497,636 shorts
The overwhelmingly Net short positions indicate that the “Smart Money” considers the rate cuts being oversold. Why do they want to short Treasury futures? If the Fed keeps the interest rates higher for longer, or implements fewer rate cuts, Treasury yields would be higher than the current price indicated. Higher yields, lower prices. Shorting Treasury futures expresses the viewpoint that Treasury bond prices would fall.
In my opinion, the bond market tends to tell a better story, compared to the stock market. The institutional nature of most participants allows the bond market to be less prone to irrational hypes and price bubbles.
Trading with CBOT Micro Yield Futures
Micro Treasury Yield Futures are low-cost instruments to participate in the bond market. Micro yields are quoted by treasury yield directly. Higher yields, higher futures prices. This would ease the burden from working the complicated price and yield conversion.
Last Friday, the February contract of Micro 2Y Yield futures (2YYG4) were settled at 4.186%. Each contract has a notional value of 1,000 index points, or $4,186 at current price. To acquire 1 contract, a trader is required to deposit an initial margin of $340.
The February Micro 10Y Yield (10YG4) was settled at 4.008%. Notional value is 1,000 index points or $4,008. Initial margin is $320.
The February Micro 30Y Yield (30YG4) was settled at 4.221%. N notional value is 1,000 index points or $4,221. Initial margin is $290.
My reasoning:
We just had a hotter than expected jobs report for December. If CPI data shows inflation rebound this week, the whole Fed cut narrative could be derailed. The January 30th Fed meeting could have a surprised rate decision, or a more hawkish Fed statement.
To replicate the short bond futures strategy used by Leveraged Funds, investors could long the micro yield futures to express the same view of higher yields. Initial margins for 10Y Micro Yield are $320, compared to $2,125 for 10Y treasury notes futures (ZN).
Hypothetically, if the yield goes up by 25 bps, a long Micro Yield futures position would gain $250 (= 0.25 x 1000). This would be the same for 2Y, 5Y, 10Y and 30Y micro yield futures, as they all have a 1,000-point multiplier.
On the other hand, if investors continue to ignore the Fed, as they have often been in the past two years, short futures will lose money.
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/
2YY1!), Micro 10-Year Yield ( 10Y1!) and Micro 30-Year Yield ( 30Y1!)The latest US jobs report showed that employers added 216,000 jobs for December while the unemployment rate held at 3.7%, reported by the Bureau of Labor Statistics (BLS). That compared with respective market estimates of 170,000 and 3.8%.
On Thursday, the BLS will release December’s CPI data. The prevailing market expectation is 0.3% monthly increase for headline CPI, up from 0.1% in November.
The Federal Reserve sets monetary policy to support price stability and full employment. New data shows that the US economy is very resilient, and maybe slightly overheated with the upbeat job market.
After hiking interest rates 11 times and pausing for 2 times, the Fed now has a dilemma. “To cut, or Not to cut”, this is a trillion-dollar question.
In this 3rd installment of new year outlook for major asset classes, I will discuss what opportunities may lie ahead for bonds and interest rate derivatives.
FYI: The first writing was a year-end review for metal commodities – Gold, Copper, and Aluminum. If you haven’t read it yet, you may follow the link here:
https://www.tradingview.com/i/Lnm0zHT0/
The second writing was New Year outlook for US equities – the benchmark market indexes Dow, S&P 500 and Nasdaq 100.
https://www.tradingview.com/chart/SPX/XjHpsvvS-US-Equities-2024-Outlook/
2023: what’s the dominating market narrative?
Last year, the Fed raised interest rates four times for a total of 100 bps. This was a slower pace comparing to the year before, where we saw seven rates hikes and 400 bps in total.
To the surprise of most analysts, businesses continue to expand and hire new workers under tightened credit. Inflation could creep up with higher wages and a strong job market.
US stock market rose for most of the year, shaking off bad news along the way. Despite interest rates are 5% higher than two yeas ago, major market indexes reached all-time-high records last December. The S&P 500 gained 23.9% for the year, and the Nasdaq Composite more than doubled that at 53.9%.
2024 Outlook for US Interest Rates
Most investors agree that the Fed will cut rates in 2024. But the expectations for the timing and scope vary significantly.
According to CME Group’s FedWatch Tool, the first rate-cut could occur at the March 20th Fed meeting, with a 69.2% probability. For June 12th, the odds of two or more rate cuts increase to 85.9%. By December 18th, investors expect the Fed Funds rate to fall between 1% to 2% lower than the current 5.25-5.50% range, with a 97.9% odds (Data as of January 7th).
(Link: cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html)
Treasury prices and yields move in opposite directions. Current bond prices reflect the market expectations of 5-8 rate cuts in 2024. Lower yields, higher prices.
The January 2nd CFTC Commitments of Traders report (COT) shows that “Leveraged Funds” hold the following open positions on CBOT interest rate futures:
• Fed Funds: 224,772 longs and 489,204 shorts
• 2Y Treasury: 775,882 longs and 2,266,563 shorts
• 5Y Treasury: 844,600 longs and 2,821,682 shorts
• 10Y Treasury: 285,598 longs and 775,882 shorts
• 30Y Treasury: 79,124 longs and 497,636 shorts
The overwhelmingly Net short positions indicate that the “Smart Money” considers the rate cuts being oversold. Why do they want to short Treasury futures? If the Fed keeps the interest rates higher for longer, or implements fewer rate cuts, Treasury yields would be higher than the current price indicated. Higher yields, lower prices. Shorting Treasury futures expresses the viewpoint that Treasury bond prices would fall.
In my opinion, the bond market tends to tell a better story, compared to the stock market. The institutional nature of most participants allows the bond market to be less prone to irrational hypes and price bubbles.
Trading with CBOT Micro Yield Futures
Micro Treasury Yield Futures are low-cost instruments to participate in the bond market. Micro yields are quoted by treasury yield directly. Higher yields, higher futures prices. This would ease the burden from working the complicated price and yield conversion.
Last Friday, the February contract of Micro 2Y Yield futures (2YYG4) were settled at 4.186%. Each contract has a notional value of 1,000 index points, or $4,186 at current price. To acquire 1 contract, a trader is required to deposit an initial margin of $340.
The February Micro 10Y Yield (10YG4) was settled at 4.008%. Notional value is 1,000 index points or $4,008. Initial margin is $320.
The February Micro 30Y Yield (30YG4) was settled at 4.221%. N notional value is 1,000 index points or $4,221. Initial margin is $290.
My reasoning:
We just had a hotter than expected jobs report for December. If CPI data shows inflation rebound this week, the whole Fed cut narrative could be derailed. The January 30th Fed meeting could have a surprised rate decision, or a more hawkish Fed statement.
To replicate the short bond futures strategy used by Leveraged Funds, investors could long the micro yield futures to express the same view of higher yields. Initial margins for 10Y Micro Yield are $320, compared to $2,125 for 10Y treasury notes futures (ZN).
Hypothetically, if the yield goes up by 25 bps, a long Micro Yield futures position would gain $250 (= 0.25 x 1000). This would be the same for 2Y, 5Y, 10Y and 30Y micro yield futures, as they all have a 1,000-point multiplier.
On the other hand, if investors continue to ignore the Fed, as they have often been in the past two years, short futures will lose money.
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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