This is a weekly chart of the difference between the front month contract and the next contract in front for S&P 500 Futures. (Don't worry, you don't need to understand this lingo to understand this post, but if you'd like more information about what front month contract and next contract in front mean, I added links at the bottom of this post. To put it simply, this chart allows us to extrapolate what the market is currently pricing in for the future).
With that said, you may look at this chart and think it looks like just noise. You'd be right: it does look like noise, literally. Below is a diagram of actual sound waves.
These sound waves are from a human voice. The sound waves of a human voice always encode a message. Likewise, this futures chart has encoded an insane message...
To decode the message in this chart, let's first overlay a moving average. It doesn't matter too much which moving average you select, but I like to use the 20-period moving average because it's usually considered the mean for a given timeframe, and is the basis for the Bollinger bands. It will help us get rid of the extreme noise oscillations and allow us to just analyze the underlying price action.
Below is a chart of the 20-week MA applied to the chart.
It's hard to see the moving average, so let's now hide the noise and only show the moving average.
The chart is much cleaner and looks a lot different. Does it look familiar at all?
If we add the Fed Funds Rate it will...
As you can now see, it appears that this S&P 500 futures chart is a leading indicator of the Fed Funds rate.
However, we cannot go by looks alone and we should validate this hypothesis. We can do this by calculating correlation values. See the below chart.
It appears that the correlation values (R, R-Squared and P values) generally seem to validate the conclusion that this S&P 500 futures chart is a leading indicator for the Fed Funds rate.
Now here's where things get pretty insane...
We can use this chart to extrapolate how high the Fed Funds rate may go.
To get a refined look, we need to use a smaller moving average. Smaller moving averages can give us a more refined picture. To do this, I will drop the moving average down to the 5-week MA.
Here's what that chart looks like...
Look how high the 5-week MA is right now. Since June, it has exceeded the highs we saw in 2007, before the Great Recession when the Fed Funds rate was 5.25%.
Right now the S&P 500 Futures chart appears to be pricing in a Fed Funds Rate of about 6%. That's considerably higher than the 3.5% terminal rate currently predicted by the Fed.
With this said, the Fed is a free agent. It is not bound to hike to the level that the S&P 500 futures, as evidenced by this chart, may be pricing in. However, there's a cost to staying behind the curve: If the Fed fails to hike enough, inflation can spiral out of control with the expectations of further inflation amplifying the upward spiral. Companies raise prices in anticipation of higher inflation, workers demand higher and higher wages and the cycle begins to spiral out of control. Whereas, if the Fed continues to hike more and more aggressively to fight inflation at all costs, despite inflationary pressures being supply-related and not just demand-related, then it will destroy the flow of credit, and force massive deleveraging.
Regardless of which path the Fed chooses, a major economic downturn is virtually unavoidable.
Months later and futures do not appear any less concerning...
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Also, I wanted to share this formula written by akikostas which uses E-mini S&P 500 Futures to precisely predict the Fed Funds rate.
The black line is the smoothened 5-week moving average
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The ratio ES2!/ES1! is highly correlated to the Fed Funds Rate.
When analyzing the forward-looking 3-week chart we obtain the following correlation values R= 0.96, R-squared= 0.95, and p-value: 0
The chart below compares the Fed Funds Rate to the 20-week smoothened moving average to show the nature of the correlation on a chart.
These facts suggest that it may be reliable to use the ratio of ES2!/ES1! as a forward indicator for the Fed Funds Rate. Doing so leads us to conclude that we may expect the Fed Funds rate to plateau.
When we use the formula shared by akikostas we see that there was volatility around the time of the SVB bank collapse.
Therefore, the plateau that the market is expecting for the Fed Funds rate, may be quite easily disrupted and turn into a whipsaw if both liquidity crises and high inflation occur simultaneously.
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