The news outlets typically report that the odds of a hike in June are about zero.  It’s NOT zero.  When is “zero” not zero?  The pricing of any Fed meeting is a function of:

  1. The odds of a hike in rates[1]
  2. The odds of an ease in rates
  3. The odds of unchanged rates, and
  4. The odds of FF effectives being different than currently.

For simplicity, let’s ignore 4.  So when you look at the various scenarios {hike, ease, unchanged}, each scenario is non-zero.  When you see “zero probability of a move”, it’s more accurate to say that the odds of an ease and the odds of a hike are roughly equal (which gets us to zero).  So you can have the odds of a hike at 25% and the odds of an ease at 25%, which would get you to zero.

As our new view develops, we should look at the breakdown in probabilities in more detail.  Here are the trade nuggets I want to build on in the coming weeks:

  • A European banking crisis or a financial crisis could see libor going higher… even on an ease. So in the above analysis, it’s possible EDs could lag on an ease.  This tilts the math in favor of owning ED puts over calls – especially if we get another huge rally.
  • An ease could be likely, but a move to negative rates looks very unlikely in the near-term (for reasons previously provided). This caps the upside on calls.  I’m not saying the Fed couldn’t go negative.  I’m just saying the hurdle is high and they can’t do it “soon.”
  • The Fed is never going to hike intermeeting, but they could ease intermeeting. So we should have some rate longs in front of all our rate shorts.

[1] For simplicity, I’m going to ignore the magnitude of possible moves and intermeeting moves.