Chart Advisor: The Market Leads the Fed

By Rich Excell, CFA, CMT

1/ The Market Leads the Fed 

2/ This Will Impact Credit Markets

3/ This Will Impact Equity Rotation

4/ Equity Sectors Saw this Coming

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1/ The Market Leads the Fed 

For full disclosure, I am writing this before the FOMC press conference today. I feel comfortable doing so because the odds the FOMC moves rates on July 31 are very close to zero. The FOMC does not like to surprise the markets. There are, however, strong odds the FOMC will cut in September and that is what the market will focus on in the press conference.

_{Source: StayVigilant.Substack.com, Bloomberg}

However, we already know what the FOMC will say and what it will do. Why? Because while many people think the market reacts to the FOMC, the reality may be more that the FOMC reacts to the market instead. In the first chart I show you three lines: Fed Funds in blue, 4-month ahead Fed Funds Futures in white, and 12-month ahead Fed Funds Futures in orange.

As we look at it, we can see the Fed Funds Futures market has led the short-term Fed Funds and the Fed Funds Target rate for the last 20 years. Even the shorter term 4-month future leads the Target rate for the Fed. Both futures (inverted here as it is price and not yield) are telling us where the Fed Funds will be: in 4 months at 5.05% vs. 5.5% for the Target now and in 12 months at 3.99% vs. 5.5% currently (100-price is yield). That is some dovishness.

2/ This Will Impact Credit Markets

We can then use the 12-month ahead Fed Funds Future to see if different market components similarly respond to this market pricing mechanism. The first market I look at is the credit market, comparing the HYG high yield ETF to the LQD investment grade ETF. Throughout my career, I have learned that the credit markets lead the equity markets so I always pay attention.

_{Source: StayVigilant.Substack.com, Bloomberg}

As rates have moved higher (inverted white price line of Fed Funds Futures moving up), one may think that the riskier credit – high yield – would underperform the safer credit – investment grade. This makes perfect sense until one realizes that when looking at these two ETFs there are two other forces that overwhelm that influence. First, the duration of the HYG ETF is much shorter than for LQD by nature of the shorter-term issuance that HY companies do. Second, a smaller impact being the sector composition as HYG has a lot of media and energy and LQD has banks and telecom.

We can see that as this inverted futures price line has fallen i.e. yields have fallen, investors have preferred LQD over HYG, extending out the duration of their portfolio. When yields have risen (price has fallen), investors have preferred shorter duration. Will investors move more permanently into longer duration?

3/ This Will Impact Equity Rotation

Duration is something that not only credit markets have but equity markets have as well. If you think about it, it makes sense. Duration is the sensitivity to interest rates. Any asset that generates cash flow has less sensitivity. Assets where the value is placed more on the future of cash flows, will have a longer duration. This is true for companies, sectors and countries.

_{Source: StayVigilant.Substack.com, Bloomberg}

The next comparison for Fed Funds Futures is the outperformance of the US vs. the rest of the world. Believe it or not, the US market is seen as the defensive market across the globe. I know that is hard to think of in a market driven by AI. However, the US market has a much lower correlation to the economy than others around the globe. In addition, the cash flow, especially of the largest companies, is much higher. Thus the US has a shorter duration.

We see this in the performance. As rates have moved higher, investors have sought the safety of the US. When rates are anticipated to move lower, the rest of the world starts to outperform. If we are about to see a long Fed easing cycle, is it finally time for the rest of the world to outperform the US? Will US investors start to move their money offshore?

4/ Equity Sectors Saw this Coming

Finally, rate expectations also have an influence on sector allocation. The duration argument is certainly at play here as is the preference and performance of the individual companies within the sector. The example I show here is the XLP Consumer Staples ETF compared to the XLY Consumer Discretionary ETF. This can be thought of as defensive vs. cyclical or safe vs. risky.

Source: StayVigilant.Substack.com, Bloomberg

There is a large idiosyncratic component, though, too. The XLP ETF is heavily weighted toward Proctor & Gamble, Costco, and Walmart. The XLY ETF is weighted toward Amazon and Tesla. Thus, when rates first started to rise back in 2022, we can see the investor preference for defensive vs. cyclical stocks as XLP materially outperformed XLY.

However, in the late summer rally of 2023 that has continued throughout 2024, we see the investor preference for the Mag & names with Amazon and Tesla leading the way. Rates moved higher but these sector ETFs did not respond in kind. Thus, we need to be careful if we think that XLY will naturally outperform on lower rates because a lot of that relative move may have already happened.

We are predisposed to think that Fed policy impacts the markets, however, the empirical evidence suggests more that the FOMC may follow the market, and the internal relative performance of the market may give us a better insight into investor forward views than the headline indices do. Stay Vigilant!

About This Week’s Author

Rich Excell, CFA, CMT is a 30-year hedge fund and proprietary trading veteran who has lived and worked in Asia and Europe in addition to the United States. He has run investment businesses spanning equities, fixed income, commodities and foreign exchange. Rich is now a Clinical Assistant Professor of Finance at the Gies College of Business, University of Illinois, Urbana-Champaign. He also is the host of the Investment Exchange Forum and Macro Matters podcasts for the CFA Society Chicago and writes a bi-weekly options trading blog ‘Excell with Options’ for the CME Group. Finally, he writes a weekly Substack blog called ‘Stay Vigilant’ which aims to demystifinance for the average investor. 

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Originally posted on August 1st, 2024

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