Market Vs. Fed Expectations For Rates Through December 2019

by: Peter Knight

Summary

Over 11 Trillion in the face value of open positions tells us we'll see 2, 0.25% rate hikes between now and December 2019.

The Fed tells us 11, 0.25% rate hikes.

In this report I'll show you how to translate price action into rate expectations through June 2026.

Full disclosure 3 of my current trades with links to monitor profit or loss.

If the Fed is right about the rates they set, trade 1 will appreciate from $3,462.50 to $9,087.50, trade 2 $1,500 to $5,875, trade 3 $2,500 to $8,125.

September 2016 through December 2019 rate hike expectation chart from 2010 through 2016

A) Current Fed expectations call for 11, 0.25% hikes by December 2019.

B) The market currently has 2, 0.25% hikes priced in by December 2019

C) The last time the market priced in 11, 0.25% hikes, November 2013.

Click to enlarge

Fed guidance

Current Fed Funds rate = 0.50%

2017 = 1.50% (4, 0.25% hikes)

2018 = 2.50% (8, 0.25% hikes)

2019 = 3.25% (11, 0.25% hikes)

(Supporting Fed video 2 minutes 12 seconds)

Source Federal Reserve

What I'm trading and how to capture this move.

The 3 month deposit contact is the most liquid futures contact on board. The face value of open futures positions currently exceeds 11+ trillion USD with underlying futures options another 4+ trillion. The forward deliveries trade out to and give the market's rate expectations through June 2026.

3 month deposit rates historically trade 0.25% to 0.50% higher than Fed Funds. When the Fed changes the Fed Funds rate you'll see a corresponding change in the 3 month deposit rate.

2009 - 2016 spread between Fed Funds and 3 month deposit rates.

Click to enlarge

To convert the contract price into the rate it represents.

Open this Exchange quote page

Take 100.0000 - the contract price = the expected rate for that delivery month. Example 100.0000 - a Sep 2016 contract price of 99.1350 = the expected 3 month deposit rate for Sep 2016 of 0.8650%.

Converting price action into the market's rate expectations for any given period.

Take the nearby delivery month, subtract the forward delivery equals the market's expected change in rates between the two delivery dates.

Example; Sep 2016 is currently trading at 99.1350 minus Dec. 2019 currently at 98.6200 = an expected increase in rates between Sep 2016 and Dec. 2019 of 0.5150%.

Click to enlarge
For more information on 3 month rates

Three of my current 3 month deposit rate trades

Trade 1

Entry and objective chart (A-D) ($3,462.50 to $9,087.50)

A) Entry date: 1 September 2016

Position: Short December 2019 (GEZ19)
Entry price: 98.6150
Contract value: $3,462.50
Margin requirement per position = $510
I'm posting $3,462.50 per position to avoid margin issues.

B) Should the market feel the Fed will make good on their word on or before 16 December 2019 the GEZ19 contract price will fall to where it was trading in September 2014.

Contract price will move from 98.6150 down to 96.3650
Expected rate will increase from 1.3850% to 3.6350%
Contract value will increase from $3,462.50 to $9,087.50
Net profit after all costs (in and out) = $5,575.00
Net return on margin requirement of $510 = 1,093.13%
Net return on contact value at entry of $3,462.50 = 161.01%

Click to enlarge

Current GEZ19 chart and quotes to monitor this trade forward
Reportable position size = anything greater than 850 contracts

I established this position 1 September 2016 trading the December 2019 contract and plan on maintaining this position until my resting profit objective at 96.3650 is achieved or I liquidate this position prior to delivery in 1,200 days (16 December 2019).

There are no "roll" costs because the position has been established in the December 2019 forward, maximum cost on this trade including bid/ask spreads, brokerage, clearing, exchange and regulatory fees $25.00 in $25.00 out (total $50.00).

There is no time decay because it's a futures position not an option. If rate expectations remain unchanged from the date I entered this trade 1 September 2016, price 98.6150 until 15 December 2019 and I liquidate at 98.6150 my losses will be a total of $50.00.

In order for me to lose my entire $3,462.50 deposit per contract 3 month deposit rates would have to go to and remain at 0.00% between now and December 2019.

U.S. taxation falls under 1256; all gains are treated as 40% short-term gains, 60% long-term gains regardless of trade duration is it 1 minute or 5 years. Example let's say you're net liquidation value for 2016 is up $1,000,000 as of 31 December 2016, 60% or $600,000 would be taxed at your long term capital gains rate, 40% or $400,000 at your short term rate. U.S. traders have to provide the total profit/loss for all trades in all accounts annually using this one page IRS form.

Trade 2

Entry date, 22 August 2016
Long December 2016 (GEZ16) 99.0450
Short December 2018 (GEZ18) 98.8200
I expect the GEZ16-GEZ18 spread to widen from 0.2500
Each 0.01 change = $25.00 per position
Exchange margin requirement = $470 per position
Reportable position size = anything greater than 850 positions

Entry and objective valuation chart (A-D) $1,500 to $5,875.00

A) At my 0.25% entry I've allocated $1,500.00 per position to avoid any margin issues.

B) 0.50% is the minimum rate increase I expect between Dec. 2016 and Dec. 2018 generating an increase in allocation valuation from $1,500 to $2,125.00, +$625, +41.67%. Last trade date for the GEZ16-GEZ18 spread at this level 23 May 2016.

C) 1.00% is my primary objective between Dec. 2016 and Dec. 2018 increasing the allocation valuation from $1,500 to $3,375.00, +$1,875.00, +125.00% per position. Last trade date for the GEZ16-GEZ18 spread at this level 2 November 2015.

D) 2.00% is the Fed's expected rate increase between Dec. 2016 and Dec. 2018, increasing the allocation valuation from $1,500 to $5,875.00, +4,375.00, +291.67%. Last trade date for the GEZ16-GEZ18 spread near to this level 25 November 2013 (1.93).

In order for me to lose the $1,500 allocated per position market expectations would have to shift from a current expected rate hike of 0.25% between December 2016 and December 2018 to a rate cut of -.035%.

Quotes/chart to monitor this trade

Click to enlarge

Trade 3

Entry date, 29 August 2016
Long December 2016 (GEZ16) 99.0550
Short December 2020 (GEZ20) 98.5050
I expect the GEZ16-GEZ20 spread to widen from 0.5500
Each 0.01 change = $25.00 per position
Exchange margin requirement = $525 per position
Reportable position anything greater than 850

Entry and objective chart (A-D) $2,500.00 to $8,125.00

A) Entry 0.55%, I've allocated $2,500.00 per position to avoid margin issues.

B) 2.00% is the minimum anticipated rate increase I expect between Dec. 2016 and Dec. 2020, increasing the allocation valuation form $2,500 to $6,250, +$3,750, +150.00%. Last trade date for the GEZ16-GEZ20 spread at this level 2 June 2014.

C) 2.75%, the Fed's expected rate increase between Dec. 2016 and Dec. 2020, increasing the allocation valuation from $2,500.00 to $8,125.00 +5,625.00, +225.00%. Last trade date for the GEZ16-GEZ20 spread at this level 25 November 2013.

In order for me to lose the $2,500.00 allocated per position market expectations would have to shift from an expected rate hike of 0.55% between December 2016 and December 2020 to a rate cut of -.045%.

Quotes/chart to monitor this trade

Click to enlarge

In order to maintain positions in trades 2 and 3 I'll have to "roll " the front delivery month quarterly, in this case December 2016 to March 2017 on or before 23 December 2016. To "roll" the position you sell the December 2016 contracts and buy the March 2017. (Your trading desk should be able to roll your positions automatically)

Why I believe the market is overly pessimistic about rate hikes

After 29 years of failed Fed policies those in control of the U.S. Government now fully control the unaudited Federal Reserve. Either the Fed does exactly what they're told or they'll be audited for the first time in their 102 history. A full audit could take many an X Federal Reserve employee off the $25,000 to $250,000 per hour lecture tour and onto the Federal correctional tour (unless protected by 18 USC 1031 statute of limitations)

Greenspan apologies for his 18 years of failed Fed policies (1987 to 2006).

2006 Fed leadership went from bad to worse, in the video below Bernanke's bio and his calls on the economy before and during his tenure as Fed chair.

Yellen at age 70 is in over her head and just doesn't have the energy, experience or leadership to handle the US's continuing economic crisis. In the video below Yellen freezes up for several minutes prior to cutting her speech short.

Fed Creditability has hit a new all time low

Fed expectations for the rate they set have moved down from 3.75% to 2.50% by December 2018.

September 2014, expected rate by December 2018 3.75% or 15, 0.25% rate hikes, 1 minute 50 seconds.

Source Federal Reserve

September 2015, 3.50% by December 2018 or 14, 0.25% rate hikes, 1 minute 43 seconds.

Source Federal Reserve

December 2015, 3.25% by December 2018 or 12, 0.25% rate hikes, 1 minute 47 seconds.

Source Federal Reserve

March 2016, 3.00% by December 2018 or 10, 0.25% rate hikes, 2 minutes 6 seconds.

Source Federal Reserve

Current 2.50% by December 2018 or 8, 0.25% rate hikes, 2 minutes 12 seconds.

Source Federal Reserve

Fundamentals

Leadership and the decisions made during the majority of the financial crisis have been beyond disappointing, see this Seeking Alpha Article.

The costliest "economic stimulus" program in U.S. history was also the largest failure, see this Seeking Alpha article.

The BLS.GOV continues to understate true U.S. inflation to contain U.S. debt service cost and all Governmental increases that are linked to the official CPI like Social Security. Currently 91% of professional traders believe U.S. inflation is being under reported, see this Seeking Alpha article.

There are few if any solutions left to resolve the U.S. debt crisis, see this Seeking Alpha article.

The good news

Extreme Fundamentals bring with them change generating powerful trends and exceptional trading opportunities. It's going to be a fun year for traders who are on their game and have strategies in place to capture these moves.

If Greece, a country with a GDP the size of Orange County, California, or the UK (3.94% of global GDP), can generate the moves we've seen, just think of how much fun we're going to have in US markets (23.32% of global GDP) with the extreme fundamentals we have and an election year on deck.

My purpose in writing these long-winded articles is to reference them on this site over the next year as I write about specific trades in shares, indices, debt instruments, currencies, metals and energies. Hopefully we'll get some online international camaraderie going as we batten down the hatches getting ready for the next leg of this adventure.

Metals are sure to shine, debt instruments look like they be a downer (rates higher), and we should have the opportunity to pick up our favorite US shares at much better prices after the selling hemorrhage stalls.

Few of my favorite US stocks and ETFs I'll be writing about using my own trades as examples (both short and long). If there is interest, I'll expand to international markets.

  • Apple (NASDAQ:(AAPL)
  • Bank of America (NYSE:BAC)
  • Microsoft (NASDAQ:MSFT)
  • Alphabet ([[GOOG]], [[GOOGL]])
  • Pfizer (NYSE:PFE)
  • Cisco (NASDAQ:CSCO)
  • Goldman Sachs (NYSE:GS)
  • Moody's (NYSE:MCO)
  • Oracle (NYSE:ORCL)
  • AT&T (NYSE:T)
  • AbbVie (NYSE:ABBV)
  • JPMorgan Chase (NYSE:JPM)
  • Baxter International, Inc. (NYSE:BAX)
  • General Electric Company (GE)
  • SPDR S&P 500 Trust ETF (SPY)
  • SPDR Dow Jones Industrial Average ETF (DIA)
  • iShares MSCI Emerging Markets ETF (EEM)
  • SPDR S&P Metals and Mining ETF (XME)
  • SPDR Gold Trust ETF (GLD)
  • iPath S&P 500 VIX Short-Term Futures ETN (VXX)
  • Market Vectors Gold Miners ETF (GDX)
  • Ford Motor Company (F)
  • Financial Select Sector SPDR ETF (XLF)
  • iShares China Large-Cap ETF (FXI)
  • Shares Russell 2000 ETF (IWM)
  • COMEX Gold Trust (IAU)
  • Physical Swiss Gold Shares (SGOL)
  • DB Gold Fund (DGL)
  • DB Gold Double Long ETN (DGP)
  • UltraShort Gold (GLL)
  • Gold Trust (OUNZ)
  • Ultra Gold (UGL)
  • DB Gold Double Short ETN (DZZ)
  • 3x Long Gold ETN (UGLD)
  • DB Gold Short ETN (DGZ)
  • 3x Inverse Gold ETN (DGLD)
  • Gartman Gold/Yen ETF (GYEN)
  • Gartman Gold/Euro ETF (GEUR)
  • E-TRACS UBS Bloomberg CMCI Gold ETN (UBG)
  • X-Links Gold Shares Covered Call ETN (GLDI)

Few of my favorite derivatives

Volatility will be high, so trade with the trend. When possible use option collars to define your risk on individual trades and for the duration of every trading period.

Disclosure

I've been a professional trader and run a family office from Tortola, British Virgin Islands for the past 20+ years, zero income, corporate and inheritance tax and would like to keep it that way. Because of the potential tax implications I do not manage US accounts, or sell an advisory service. I do however manage funds for a limited number of non U.S. investors. I may at times for my own accounts or for funds I manage have positions on that could be contrary to the ones mentioned in these reports.

Disclosure: I am/we are short MANY US AND INTERNATIONAL DEBT INSTRUMENTS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.