Trading the Fed
With the Fed trending in the news recently, here's how institutional market makers trade the Fed.
The Federal Reserve is the central bank of the United States, established as a direct response to a series of financial panics in the early 1900s: the nation’s first set of diamond hands.
And just like our favorite group of diamond hands, the Fed has moderators: the “Federal Open Market Committee” or FOMC. They ensure the delivery of the "dual mandate” of maximum employment and price stability:
Maximum employment means getting as many people employed as possible. Too many people in jobs makes salaries go up though, which can mess with price stability.
Price stability means targeting a 2% increase in the cost of living to the ‘average’ person, year on year. If you’ve heard of CPI, it's just measuring this with a ‘representative basket’ of goods, which apparently includes “fresh cakes and cupcakes”, “synthetic wigs” and golf club memberships… Traders watch the Fed’s performance to assess what the Fed is likely to do next - more on that later.
How Low Can They Go?
President Trump famously wants JPow to cut interest rates to stimulate the economy.
Lower rates means people can BORROW cheaply: consumers and businesses can get loans, mortgages, and other forms of credit, without worrying about making money to pay them back any time soon.
This is great for business, which feeds back into the economy: businesses pay their employees, and everyone has more disposable income. It’s especially good for businesses that have a long road to profitability, like Silicon Valley startups (us).
This is called the “expansionary monetary policy”.
However, the stimulus of low rates comes with a potential trade-off: inflation.
If everyone has more money, businesses will increase the price of goods and services, and their employees will start to demand higher wages. This can be especially bad if there are a lot of job vacancies.
You only need to look back to 2022 (when interest rates had been cut to 0% after COVID) to see what happens if rates are too low.
What to Watch Out For
The Fed enforces its rate decisions by trading in the markets for borrowing and lending U.S. Dollars itself.
Traders are constantly on the lookout for indicators from central bankers about what their thoughts are on interest rate policy, to try to predict and monetize future moves.
The Fed usually schedules market-moving events well in advance, like:
Employment Data (Nonfarm Payrolls, Unemployment Rate): The Nonfarm Payrolls report (on the first Friday of every month) is the most anticipated economic release on any trader’s calendar, and usually leads to significant volatility. It gives statistics on employment in the U.S. except the agricultural sector (which is very cyclical). Strong job growth can indicate a robust economy, but also wage inflation. It’s interpretation is so interesting that we are leaving it for another article… In May 2024, the report was accidentally published 30 minutes early on an unindexed link. Nobody seemed to have noticed.
Inflation Data (CPI, PCE): Consumer and producer prices, respectively, measure the Fed's ability to keep prices stable. Higher-than-expected inflation can signal a need for rate hikes.
GDP (Gross Domestic Product): GDP indicates the overall health and growth trajectory of the economy, influencing the Fed's assessment of economic strength and potential policy responses.
Retail Sales, Industrial Production and Consumer Confidence: Consumer spending is a huge part of U.S. GDP - these indicators provide key insights into overall economic sentiment.
FOMC speakers: Statements and speeches from central bank officials, particularly the Fed Chair (currently JPow), are closely monitored by traders. Even subtle shifts in tone or emphasis can trigger significant market reactions. You might have seen coverage about Jackson Hole recently - this is the Super Bowl of the central banking world, and JPow is the all-star QB. This time, JPow indicated that the Fed is preparing to start cutting interest rates again; this is great for equities (particularly tech stocks) for the reasons we discussed earlier. Traders call this response “dovish” (the opposite is “hawkish”).
The World's Central Bank
In an increasingly interconnected global economy, the actions of the Fed reverberate far beyond the borders of the United States.
The sheer size and influence of the U.S. economy, coupled with the dollar's role as the world's primary reserve currency, effectively position the Federal Reserve as the world's central bank.
Tracking data prints like U.S. Nonfarm Payrolls and being on top of central bank speeches like Jackson Hole are crucial for anyone looking to navigate the world of macro trading.