CFDs Explained

By: IS
Date posted: 09.21.2016 (1:50 pm) | Write a Comment  (0 Comments)

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The next Federal Open Market Committee (FOMC) meeting will occur in late September 2016. There have been many arguments both for and against an interest rate hike in September. Now, whether the Federal Reserve decides to raise or leave the Fed funds rate, major market indices should be affected. The Standard & Poor’s 500 Index (S&P 500), Nasdaq-100 Index and Dow Jones Industrial Average should react to the Fed’s decision in September. Now, instead of trading options, futures or exchange-traded funds (ETFs), some market participants may want to consider contracts for difference (CFDs). Now, some may be wondering what CFDs are and how these products function.

CFDs Explained in Brief

A CFD is a tradable financial instrument that seeks to mirror its underlying asset’s movements. Now CFD trading is less costly than trading options, futures or ETFs, since CFD investors and traders do not have to own the underlying asset and are not obligated to do so.

CFDs allow market participants to speculate on market prices, regardless of the direction of the underlying asset. For example, if an investor is bullish on the S&P 500 Index, the investor could purchase CFDs tied to the index. Consequently, the investor would benefit from a rise in the S&P 500 Index. Conversely, if an investor is bearish on the S&P 500 Index, the investor could sell short CFDs tied to S&P 500 Index, therefore, the investor would benefit from a fall in market prices. Therefore, risk tolerant investors who understand the product could use CFDs during the next September FOMC policy meeting.

Arguments for Fed Funds Rate Hike

Goldman Sachs’ Chief Economist Jan Hatzius is one of the few economists who believe the Fed will raise interest rates during the FOMC’s September meeting. Jan Hatzius argues that the U.S. economy is adding jobs at a pace that is satisfactory for many members of the FOMC to vote for an interest rate hike in late September. Although the August U.S. Employment Situation report came in weaker than expected, one month’s disappointing numbers does not reflect the overall trend.

Federal Reserve Chairwoman said, “Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months,” at the Jackson Hole, Wyoming annual summit.

Moreover, Hatzius stated, “Growth in nonfarm payrolls was weaker than consensus estimates at +151k, but above the pace Fed officials typically consider sufficient to hold the unemployment rate steady over time—the so called ‘breakeven rate … we therefore see this report as just enough for a large majority of officials to support a September rate increase. We have therefore raised our subjective odds of a hike this month to 55% from 40%.”

Although the U.S. economy only added 151,000 jobs in August, which was well below consensus estimates, the moving average over the past three months is an average addition of 232,000 jobs. Consequently, the risk of a recession occurring over the short term is low and the Fed could raise rates.

Arguments Against Fed Funds Rate Hike

Conversely, there are economists who believe that the Fed is unlikely to raise rates in September. Canaccord Genuity’s chief market strategist said, “I don’t think they’ll hike in September … the economic cycle is not about duration. The economic cycle is driven by Fed policy, short-term interest rates, which create strength in the long-end of the curve.” With all this chatter regarding interest rates, it’s difficult to discern whose arguments are stronger. Either way, investors should be gearing up for the potential Fed rate hike.

As stated previously, it is expensive for some investors to purchase options and futures on the overall market. Investors who wish to place a trade on whether the market will go up or down could place trades on CFDs related to the Dow Jones Industrial Average, S&P 500 Index or Nasdaq-100.

 

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