The Sept meeting is about 3.4 bps priced. Considering the “forward looking” ISM indicators and Retail Sales were weaker, I don’t see the higher CPI outweighing those other factors. 3.4bps seems a little low, but nothing I would want to take a direct punt on. There seems to be a few analysts also saying this seems low, but as I’ve mentioned before, it’s a little reckless to hike when the markets aren’t pricing it in and libor has been creeping higher (especially relative to FFs).
The most likely and reasonable path, is for the Fed to skip now, and at the November meeting, signal a move in Dec (assuming the data holds up). Below are the three basic scenarios for the September meeting, with my estimate of the probabilities. It merits some discussion because all three possibilities are > 10% in my mind:
- Fed hikes (15% probability). FFV will sell off over 21bps. This will shock the markets, with the curve bear flattening – the very front end will sell off and the longer end should flatten. The hurdle for a hike will be lower than the markets expect, and so you could see additional low-priced meetings in the next 6-12 months be priced in. Basically, it would be similar to the market reaction Friday on the higher CPI print, but with the peak closer to the whites.
- Fed does not hike, but has a more hawkish action statement (15%). I actually thought this was a higher probability outcome, but this was before all the data turned softer this month. It doesn’t really make sense to take the step toward a future hike when you aren’t sure how the data will come out. The November being less than a week before the elections makes it a little difficult to suggest action at that meeting. But this could be a band-aid to assuage the hawks and to give the markets some warning. FFV will rally over 3bps, but Nov and Dec probabilities should increase, as could some of the early 2017 meetings.
- Fed does not hike, but there is no action statement (70%). This would be the status quo. While this is the most dovish of the three scenarios, presumably they would have slightly upgraded their assessment of the economy, so it’s not clear how much Nov and Dec would go down (if at all). The no-move would drag EDs a few bps higher, but this will vary depending on how the rest of the statement reads.
Here are some of the more interesting instruments we have to implement a view before and after the meeting:
The most direct play would be FFV6. If you think the Fed hikes, you can sell FFV6 @ 99.575 (or try to get a half bp better). FFV has three month-end days so you figure it should settle around 99.359 on a hike and 99.609 on a no-move, assuming the following Conditions: (1) the regular FF effective days keeps coming in at 40bps, (2) the month ends come in at 9 bps below the regular days (31bps). These assumptions are obviously subject to change, and could be volatile (relative to previous months). All other things being equal, you should be making over 21bps on a hike from selling FFV. On a skip, it’s possible 99.60 could trade if enough longs want to get out. That could be a reasonable flip trade. On a hike, I’m less confident about Condition 1 holding (it’s not clear if the regular days keep coming in at 40bps). The other thing to watch for is that the new money rules go into effect in the middle of the contract (Oct 14). It’s possible we could see the two Conditions change. It’s not inconceivable to me that we could have a shift back down in the Fed Funds effective rate later this year if libor settles down. I suppose there is also the chance that the FF effectives could blow out more on a skip, but I tend to think the risk is on lower FF effective rates than higher (assuming there is a change at all). This is because I think libor spreads are more likely to come in by the end of the year and this could drag the Fed effectives lower, on the margin. The markets have been pricing in lower libor-FF spreads by year end – EDZ-FF spreads have been about 4-5bps lower than EDU-FF spreads. Risk of lower FF effectives could mean some upside risk to where the entire FF futures complex settles, on the margin. This could make it more attractive to be long FFs (in general, not just FFV) in various structures. However, the spreads could get very volatile next month. So some caution is warranted, unless you have a strong view.
EDV6 99.00 puts:
In looking at ED options, EDV 99.00 puts are interesting. They settled at 1.5. At that level, it’s close to offering similar Fed odds as FFV. It really depends on what you think will be priced in for the Nov, Dec and Feb meetings in the various scenarios. You would think the Nov meeting should go to “zero” on a Fed hike. But what happens to the ~9.5bps in Dec after a Sept hike? You could argue the Fed could be more likely to hike again after a Sept hike (a few members did say “one or two hikes in 2016” and the hike hurdle would be lower than the markets thought), and you could argue that the Fed would be less likely (the data has been turning softer so we may only 1 hike needed in 2016). I don’t have a strong view on this, mostly because I would be shocked if they did hike. However, assuming they hike, the 9.5bps seems like a reasonable enough assumption. If we assume Sept goes to 25bps, Nov goes to 0bps and the rest of the curve stays the same, that would put EDZ at 98.87. That means the EDV6 99.00 puts will be 13bps ITM. This may be better risk than selling FFV. With FFV, your reward to risk is 21.6:3.4 (or 9.5:1.5) and with the put, your ratio at “settlement” is 11.5:1.5. Buying the put also has some other advantages: (1) it will not go to zero after the FOMC decision – it’s not going to zero with 3+ weeks left and EDZ6 being between 5 and 10 bps OTM, (2) you get a kicker if libor-FF blows out before the Oct 14 Treasury money rules go into effect, (3) you can get a kicker if the Fed does not go in September, but says something very hawkish. In fact, the three things above are so attractive, It may make sense to buy the puts vs something else. You could also buy the 88-90 put spread to improve the odds. The main drawback would be if the Fed hikes in Sept and says they are done for the short term. That would be a low probability painful event, but still possible.
I have said for a while that we should look at “EDZ options trades” for quite some time in the Value on the Horizon section. It was hard to pull the trigger on anything because for the past few months because we went from pricing in an ease to two hikes being plausible in 2016. That is too wide a range in a data-dependent environment. However, we are now getting to the point where the Fed outcomes are becoming narrower. In particular, on a skip, it will be almost impossible for the Fed to hike 2x in 2016. Yes – it’s mathematically possible. Just not very likely with the elections and so little time left. The EDZ straddles at around 14bps gives you a 28bp range where you can profit. You need some crisis protection (see F30b), and we have some noise with the Treasury money rules, but if you have a strong view on the Fed outcome this year, you may be able to find some structure that fits your risk/reward profile. You can also consider the EDV or EDX straddle, which expire before the Dec meeting. The EDV expires when the new money rules go into effect.
I think there are some nuggets of value here. Let me see where the markets are before the Fed meeting and I’ll send you any thoughts. If we get some volatility around the BOJ meeting, we may get a good opportunity to put something on. For now, I think there’s a little value in buying FFV vs overbuying EDV 90 puts (2+ times). It would mostly be to get the EDV 90 puts for “free” on a Sept skip. I don’t think there’s enough there to do in large size and it certainly could be volatile, but I suppose if your view was that the Dec meeting would become more priced, then there could be value here. If you have a particular view, let me know and we can discuss as well.