It continues to explode, and this is a bad sign.
Since the S&P 500 futures price includes the risk-free interest rate, the spread between the two contracts gives an idea of the market’s expectations for future interest rates.
To understand why the interest rate is used in pricing futures contracts, one has to understand futures contracts.
Futures contracts are agreements to buy or sell an asset at a predetermined price at a future date. The price of a futures contract is determined by a number of factors, including the current spot price of the underlying asset and the cost of holding the asset to maturity.
The interest rate is used in the pricing of futures contracts because it represents the cost of bringing the asset to maturity to the seller of the contract. Since the seller of the contract could hold his money in a risk-free Treasury instead of the S&P 500, the risk-free rate is therefore the opportunity cost to the seller, for which he must be compensated. Therefore, the risk-free rate is used because it represents the minimum return that must be earned for a rational market participant to sell an S&P 500 futures contract.
Since each S&P 500 futures contract must trade at the interest rate, the spread between the sequentially expiring contracts indicates the market’s expectation of the future direction of the interest rate.
In this sense, the difference between the sequential futures contracts guides the Federal Reserve’s monetary policy, specifically the Federal Funds Rate, as shown in the chart below.
On the other hand, the inversion of the yield curve is steepening the most in more than 40 years.
Below is the difference between the 10-year US Treasury and the 2-year US Treasury.
The relationship between the 10-year US Treasury note and the 3-month US Treasury bill is even worse, as shown in the chart below.
I squared the values for periods in which the 3-month Treasury bill yield went into negative numbers.
What does this all mean? It means that a US recession is surely coming, and it is likely to be stagflationary in nature.
If you want to hear my full thoughts, you can watch my video below.
When will the recession start?
The infographic below, created by Fredric Parker, uses a probability distribution to infer that a US recession will most likely start before the end of 2024.
The New York Federal Reserve puts the chance of a US recession after May 2024 at almost 71%. This is its highest projected probability of a recession in over 40 years, even higher than the dotcom crash and the Great Recession.
The amount of
the volatility that will occur when the yield curve attempts to normalize will likely be out of series.
This is evidenced by the fact that S&P 500 volatility is sinking to cycle lows as bond volatility explodes at the highest exchange rate on record.
To read more about this, you can see the post below that I co-wrote with @SquishTrade
That being said, July tends to be bullish and markets tend to be irrational. So maybe the bullfight will continue…for now.
Historically, the S&P 500 has often rallied late in the tightening cycle, just when the market thinks rate hikes will come to an end, but before the market realizes the damage they’ve caused.
In the meantime, all of this is occurring as the yearly stochastic RSI for the
shows very strong downward momentum, to a degree only seen during significant economic downturns.
Once a recession starts, it can last a long time or it can come in the form of multiple recessions. Central banks will fight the fires with more money, worsening inflation and causing swings in monetary policy. Worst of all… During periods of severe economic downturn, great political instability and geopolitical conflicts often occur.
Central banks need scapegoats for their failures in monetary policy.
Nothing in this post should be considered financial advice. Trading and investing always involves risk and one should carefully review all such risks before making a trading or investment decision. Do not buy or sell any security based on anything in this post. Consult with a financial adviser before making any financial decision. This post is for educational purposes only.