How Another Fed Rate Hike Could Impact SPY

Fed funds futures are pricing in a 94% chance of a rate hike at this week's FOMC meeting

Senior Vice President of Research
Sep 24, 2018 at 8:47 AM
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"With the SPX entering the week trading around last month's close, the late-August high around 2,915 serves as a potential short-term resistance point and the January 2018 closing high at 2,873 should continue to act as support... If the resistance and support levels discussed above are broken, I could see the SPX 2,850 half-century mark as another area of support. SPX 2,940 would likely act as short-term resistance, which is a round 10% above the 2017 close...

"...due to many of the options being sold to open, the current open interest configuration suggests a dull expiration week. At the very least, it is not a week in which options are likely to magnify major moves, as options that are sold to open typically dampen, rather than enhance, volatility. That said, if there is a catalyst that pushes the SPY through the call-heavy 291 and 295 strikes, the prospect of the call sellers closing their positions to manage losses would have bullish implications as floor traders unwind short positions associated with those calls."

-- Monday Morning Outlook, September 17, 2018

Despite President Donald Trump announcing tariffs on another $200 billion in Chinese goods, the S&P 500 Index (SPX - 2,929.67) rallied during September options expiration week. The tariff news was much anticipated, and the 10% rate that was announced was less than expected. Moreover, bulls got a little help as sellers of the SPDR S&P 500 ETF Trust (SPY - 291.99) 291-strike calls liquidated positions, likely adding to short covering as the SPY and SPX took out their respective all-time highs set in August. Although it was set up to be a dull week, it was anything but, as bulls enjoyed a lift of 0.8% in the SPX.

So now what? From a technical perspective, the SPX comes into the last week of the quarter trading near a potential resistance level that I mentioned last week in the 2,940 area. This level represents the site of a round 10% 2018 gain, which might inspire some profit taking. It is also near the top of a channel that connects higher highs and higher lows since April. Currently, the top of the channel is around the 2,950 half-century mark, but it is rising, implying the top of this channel will move higher with the passage of time.

spx daily chart with ytd 10 pct

As the SPX and SPY made new highs last week, so too did the Dow Jones Industrial Average (DJI - 26,743.50). The Dow not only traded in new-high territory, but distanced itself from the 26,000 millennium mark, after hitting a speed bump here in late August and at the beginning of this month.

But not all equity benchmarks are overtaking psychological round-number levels. The Russell 2000 Index (RUT - 1,712.32) did not hit a new all-time high last week and instead probed the round 1,700 area for the second time in as many weeks. While the index remains above 1,700, it has not been able to make a significant move above it since first touching this level in June. Meanwhile, the Nasdaq Composite (IXIC - 7,986.96) continued to dance around the 8,000 millennium mark last week, which has been the case since late August.

In short, potential resistance on the SPX is not far above current levels, and other benchmarks are struggling to take out key round numbers. Moreover, the SPY and SPX enter this week with their 14-day Relative Strength Index (RSI) readings very near overbought territory -- which has been the case on multiple occasions since May, but only resulted in limited downside movements, at worst.

"Companies typically don't repurchase their own shares in the month before reporting quarterly results due to regulations, and with the third quarter coming to an end, 86% of the S&P 500 will be restricted by Oct. 5, according to Goldman Sachs analysts led by David Kostin."
-- The Wall Street Journal, September 18, 2018

The current overbought condition occurs simultaneous with a blackout period for share buybacks and a Federal Open Market Committee (FOMC) meeting scheduled for this week. Fed funds futures traders, per the CME Group website, anticipate about a 94% probability of a rate hike. Prior to the mid-June FOMC meeting, the SPY was similarly overbought, the Fed raised rates, and the SPY drifted lower into the end of the month, before rallying back to its pre-Fed closing levels by mid-July.

In fact, during the current tightening cycle, one-month SPY returns following a Fed rate hike have significantly trailed one-month returns following a Fed pause. Per the table below, when the Fed has raised rates, the average SPY return one month later is a loss of 1.15% with the chance of the SPY being higher one month later slightly higher than a coin flip. In comparison, following the 22 occasions where the Fed held rates steady, the SPY was positive one month later 77% of the time, averaging a return of 1.48%.

spy after fed raises rates

With a Fed rate hike on deck, share buybacks on SPX components expected to slow, the SPX itself overbought with potential resistance just overhead, midterm election uncertainty likely to be a growing story in the weeks ahead, and a lot of short covering on SPX components occurring since early July (see chart below), prepare for a growing likelihood of choppy trading if the FOMC indeed raises rates as Fed funds futures traders expect.

spx component short interest 0921

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