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We Were On A Break (FOMC Preview)
With likely confirmation of a pause in hikes going forward, we flag up everything to watch out for today.
A 25bps hike is all but confirmed, but the main focus is on whether a pause from here is signalled.
With more issues since the last meeting for financial stability (e.g First Republic) we feel the Fed turn more cautious.
Inflation is falling, but remains above target. This is the main risk to our view of a dovish outcome this evening.
Today at 14:00 EST (18:00 GMT), we get the latest US Fed rate decision, followed by a press conference with Chair Powell half an hour later. Here’s a rundown of what we are watching for and trade ideas for making a play.
Ignore the hike, are we pausing?
A 25bps hike is nailed on, both in terms of what the market is expecting and from current investor positioning. We can see this from the implied probability below, with a 86.7% chance of the base rate being increased to the 5.00-5.25% banding.
If we do see such a move, there is unlikely to be any major reaction in the equity, FX and fixed income space. What really matters is where policy goes from here.
The Fed dot plot highlights where committee members see rates out into the future. Investors can plot these ‘dots’ and blend it together to get a feel for where the average is.
In the very short-term, the main point to note will be where consensus thinking is for the next few meetings over the summer. The chatter is that a pause will be announced, effectively meaning that this hike takes us to the terminal rate for the US.
If this is backed up by comments by Powell in the presser, we’d expect so see a USD sell-off, with stocks rallying as a result.
Let’s talk about the ‘R’ word
From our own reading, the chances of the US falling into a recession over the next year are pretty much 50:50.
Even though we don’t feel such probabilities can be that reliably computed, it’s worth noting the US Recession Probabilities put out by Estrella and Mishkin. It currently predicts a 57.7% recession chance when looking out 12 months.
Why are we flagging this up? Well we feel that the Fed are going to be pivoting to a more cautious approach going forward with policy moves, based on recession concerns. Of course, inflation remains THE key target (more on that below), but issues around financial stability (cough First Republic cough) and early signs of a cooling labour market we think will play on the minds of the committee.
For example, Non-Farm Payrolls last month came in at just 236k. We feel this points to signs that companies are struggling with the weight of lower demand and higher input costs. For the latest reading due out on Friday, expectations are for just 179k, which would easily be the lowest reading over the past year.
Powell still at war with inflation
We expect Powell to still hold to his rhetoric of wanting to get inflation further under control. Even though the CPI measure has dropped significantly down to 5% last month, we do flag that the core measure (stripping out more volatile items) ticked up to 5.6% (shown below).
This is the key risk to our view of a weaker dollar / stronger equities from the meeting tonight. If the FOMC are still not happy with the projection of price levels going forward, they could indicate that further hikes are on the table for later this year. Given that the market is pricing in cuts into the end of the year, this rapid repricing would see a knee jerk lower for stocks.
It is a risk, but there’s also a difference between what Powell says and if the market chooses to believe him. We’ve seen this happen in the recent past, and could easily happen again tonight.
Ways to trade tonight
Often, the initial reaction to the Federal Reserve rate decision is strong. We like to play this move only via a strangle or straddle options strategy. A summary of both of these can be found in this tweet.
Given the high probability of a 25bps hike already priced in, this idea only really makes sense tonight if you feel the Fed won’t hike at all, or go aggressive and move by 50bps.
However, when looking back at previous meetings, a fair few initial moves have reversed. So here is a strategy to keep in mind as well as some examples of previous meetings.
May 4, 2022 - SPY dropped from 418.20 to 414.10 on the rate release. After testing the low of day with that drop, SPY reversed and very nearly crossed 430.00. That represented a 3.75% move on the underlying. There’s no doubt some traders made a killing on calls with that move. $7 down. $15 up.
July 27, 2022 - a similar reversal played out: down before up. SPY dropped $1.10. Price then reversed $7.40 and hit a high of $402.90 30 minutes before the market closed.
November 3, 2022 - The same reversal, but this time the S&P made a move up first before reversing and closing the trading day at a new low. A $6.50 move up was quickly reversed by a $12 sell-off.
February 1, 2023 - You know what happens by now. The initial move was a $2.30 decline, quickly followed by an $11.30 rip to close at a 5-month high.
Knowing the first market reaction to the rate hike is like flipping a coin. If you could be certain, you’d be the most sought-after asset on Wall Street.
But as history shows, there is a high probability of a reversal.
Don’t go near 0dte options for this idea. There are only 90 minutes until expiry after Powell starts speaking. Yes, they are nice a cheap, but they are cheap for a reason. This strategy will work much better if you focus on Friday expiries.