Will Economic Improvements Signal a Rate Hike?
Fundamentals
Traders have been inundated with economic reports the past two days, with the upshot being that the economy is showing signs of improvement. On Tuesday, the Commerce Department released the data on U.S. retail sales for August which showed the "success" of the "Cash for Clunkers" program, as overall sales rose by 2.7%. This was well above the 2% rise most traders were expecting. Even without auto sales, retail sales rose a much better than expected 1.1% last month, which shows it is hard to keep the U.S. consumer down. The August Producer Price Index rose a much higher than expected 1.7% in August as energy prices rose by 8%. However, the so-called "core" rate, which excludes energy and food prices, rose a more moderate 0.2%, which should help alleviate fears that inflationary pressures are rising. The Empire States Business Conditions Index recorded its highest levels since the fourth quarter of 2007, when in September it rose to 18.88. This is well above the worst reading seen back in March, when the index was -38.23. Although the data seems to be confirming the worst of the nearly 2-year long recession is behind us, government officials remain cautious. Federal Reserve Chairman Ben Bernanke said on Tuesday that he believes it is likely the worst of the recession is behind us, but recovery will be hampered by credit conditions and a weak labor market. This cautionary tale being expressed by the Fed Chairman may be a signal that the Federal Reserve is in no hurry to raise rates anytime soon. Looking at the Fed Funds futures, it appears the odds of a rate hike will start to increase once we enter 2010. However; many traders believe it won't be until the end of the first quarter when we may see the Fed begin their rate-tightening cycle, and if history is any guide, once the cycle begins we should expect to see a steady increase in rates for many months.
Trading Ideas
Traders looking to speculate regarding when the Fed will move on interest rates may want to consider using Fed Funds futures. The contract price is calculated by taking the perceived average Fed Funds rate for the month and subtracting that rate from 100. So, for example, if the market believes the average fed funds rate for October will be 1.25%, then the price of the October futures contract will be 100 - 1.25 = 98.75. The May 2010 Fed Funds futures contract is currently trading at 99.495, which implies an average Fed Funds Rate for May of 0.505% (100-0.505=99.495). Currently, the Fed's target rate is between 0 and 0.25 percent. Traders who believe that the average rate will be higher than 0.505% in May might choose to sell the May Fed funds futures contract, while traders believing the average Fed Funds rate will be less than 0.505% in May might consider buying the May Fed Funds Futures.
Technicals
Looking at the daily chart for the May 2010 Fed Funds futures, we notice the uptrend line formed from the August 7th lows has been broken. The market has consolidated, as recent economic news has painted a more positive picture of the economy going forward. Traders may wish to remain mindful of the 20-day moving average, which is currently near the 99.44 area, and a close below this widely watched indicator could spark additional selling, as well as test support near the 99.30 area. The 14-day RSI has moved just below overbought territory, with a current reading of 63.17. The recent highs at 99.545 look to be the next resistance level for the May futures.
Mike Zarembski, Senior Commodity Analyst
