Now that we are at a potentially critical juncture in the markets, I like having the following three components in a portfolio:

 

  1. SOME FORM OF CRISIS PROTECTION. I know I just said the Paris terrorist attacks weren’t going to affect the Fed. But this was conditional on no further ripples.  There is value in owning overweighted call structures, whether it be in the form of Trade E28 (overweight 2EH calls vs 4EH calls) or in the form of Trade E29 (overweight EDH calls vs FFJ).  Vol is going to explode if we get an “event.”  I just think if you can structure something for “zero,” you might as well get some on.  This is a tail probability, but with eyes on a Fed hike, no one is really looking at aggressive upside.  If you have no view, you can always just buy some “ease” calls for cheap or do some kind of way-OTM risk reversal.  Several of the Fed members have said that they will be slow to raise rates after liftoff.  I think you can probably find some rate level where you feel comfortable selling way-OTM puts and buying way-OTM calls.

 

  1. SOME FORM OF GOOD RISK/REWARD “LIFTOFF” TRADE. If your view is that the Fed doesn’t hike, there are plenty of cheap looks. The reason I put “liftoff” in quotes is that I think the Fed will intentionally move slowly in the beginning, so they may be more “predictable” in the first few moves.  Who knows if the Fed will be hiking next September, October, or December?  A lot of things can happen between now and then.  But in my opinion, the Fed looks like they will hike in Dec and March.  The data is holding up more than reasonably enough for a Dec hike.  I have been saying for months that the Fed (for example, Fischer) is looking for the huge drops in inflation that occurred in the Nov ‘14, Dec ‘14 and Jan ’15 PCE data to roll off in coming months.[1]  I think if yoy headline PCE inflation is north of 1.5%, the Fed hikes again in March.  I’m a little surprised no one liked (that I know of) that FFJ vs EDH risk reversal trade… I’ll try and pick a different look.

 

  1. SOME FORM OF TERMINAL FED FUNDS TRADE. In a typical hiking cycle, the central bank is typically priced to be “done” within a few years, so reds or greens lead the selloff. One of the reasons I liked the negative double flies further out the curve is that I think the Fed hiking cycle is going to be much longer than people think.  I do not think the economy is at any risk of “overheating.”  The catalyst just is not there.  So the Fed will want to leave some accommodation for the markets, for an extended period of time.  And for the conspiracy theorists out there, a slow hiking cycle also helps the Fed’s own P&L on their bond holdings.  I do not think this factor is a serious consideration.  But it’s just win-win all around, for the Fed and the economy.  ED13 thru ED15 1 year fly settled at new 1 year lows.  This close was probably a touch low.  I’ll look at this early next week to see if there is a good trade here.  Stay tuned.

[1] The PCE data release for a given month occurs about 4-5 weeks later.