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I have an opinion that the market is wrong about the trajectory of the Federal Funds Rate over the next several months. Specifically, I think we're in for 0.75% rate hikes through the end of the year, and possible rate hikes in early 2023. I don't think a recession will appear by the end of this year, because we're in a self-perpetuating cycle of consumers pulling ahead their purchases to avoid price hike / rate hikes, and all this consumption will keep employment propped up. My projection is strongly at odds with the market consensus as shown by the probabilities implied by the futures market on the Federal Funds Rate:
https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
Basically, the market thinks there is a less than 3.7% chance rates will be 3.75-4.00% in May.
I'd like to place a wager or a hedge on this opinion, but I'm not sure exactly how I'd want to do that. I'm uncomfortable with using futures because I'm a novice in that market and generally avoid derivatives with unlimited potential losses. Thus in the world of options I'm looking at:
1) Options on the Federal Funds Rate as shown here. Benefit: directly bet on my hypothesis and avoid the risk of being right but betting wrong. Downside: lack of familiarity or sense of volatility. Would need to invest many hours of study.
2) Indirect route: long puts or bear spreads on TLT or ZROZ. Benefit: ease of use, easy to understand. Downside: These are bets on the long end of the curve which may not change as much as the short end. We could have an even crazier inversion.
3) Very indirect route: long puts or bear spreads on stock indices. Benefit: low bid-ask spreads. Ability to directly hedge a stock portfolio. Downside: Slight risk of being right about the FFR, but stocks rally anyway in anticipation of future earnings or rate cuts.
Thoughts?
What an interesting post. Thank you.
I never attempted to trade the FFR, so I don't have any personal experience with it, but I'll give it a shot. To your points:
1. Save yourself the hassle and stay away from FFR options as these are highly illiquid. There is no meaningful volume or open interest in any of the ATM strikes. Even if you do end up right in your prediction, you would have a hard time exiting the position. (Unless you want to go into expiration and then buy the future contract which can sold for a profit, but you get my point).
2. True, both of these ETFs hold long duration bonds and so would not necessarily give you the kind of exposure you're looking for. You're right, they can even go the other route if the YC inversion becomes deeper. I guess you could use some short-dated bond ETFs like SHV, but these ETFs barely move at all and therefore don't have liquid option markets. You would also have to buy a bunch of them to get any meaningful exposure.
3. Equities won't give you the kind of exposure you're looking for. I agree that the SPX will most likely fall in the case of further, yet to be priced in rate hikes. But that's another layer of uncertainty that you'd probably want to avoid in your case.
If I were you, I'd buy a FFR future contract and simply put a Stop-Loss sell order at the maximum loss I'd be willing to incur. The only thing left for you to do is to calculate the number of points that equal your max loss, and then enter the stop price at that point. I admit that this is not so straightforward because of this wacky FFR future contract and it's non-standard specs' but it can be done in a few minutes. Also, since this is a future contract we're talking about, there's no real jump risk between sessions. Naturally, a Stop order will sell at market once triggered and could result in a bad fill price, but I guess that's a risk you'd have to take. You could put on instead a Stop-Limit order, which will prevent a bad fill at the risk of not getting a fill at all. That's up to you.
The same can be done with US-T yield future contracts, such as those that trade on ECBOT. For example, the 2-year yield (2YY) would be a good match for you. I think it has more intuitive specs and is highly liquid. This would lower the risk of a stop order and help with the trade preparation.
The only obvious option that didn't come up is Forex. Eurodollar futures, USD.JPY, DXY futures... and so on. There's a whole world of products that can be used for your purpose. But that's a different story.
Good luck!!!
A friend added that you could also go straight to the 2Y treasury bond future contracts (ZT). These also have future options listed on them that should be more liquid.
I like the idea of contracts on the 2y note, but don’t like the idea of using futures due to the massive downside potential. These would also be a learning curve for me, because this is such an odd trade for an individual investor to consider. There’s be a lot to learn about position sizing, margin, stops, etc.
My broker’s help desk informed me they don’t support CME options on treasuries or the FFR, so there’s another barrier.
Good point. I agree with that assessment. The path for the FFR is now way below the June FOMC forecast. If anything, the September FOMC forecast will lift that path even more. James Bullard (St. Louis Fed Prez) is making some noise that he prefers 75bps. But even at 50bos per meeting, we will quickly get way higher than most people predict right now.
So, as a bet with some play money, I'd just go for the FFR futures. There's no need to go the options route as they are illiquid. But the futures themselves should be liquid enough for your purposes.
Good luck!
While I agree with @ohadost's assessment that the fed should maintain with the aggressive hikes above the market's current expected path, I think there's decent chance that they pull off the accelerator after Sept.
For instance, the inflation numbers coming out in in Oct and Nov have a good chance of coming down since they are using Oct and Nov of last year as the base year for year-over-year changes which was when prices really started to shoot up. Also, if Q3 GPD numbers that come out in Oct indicate a 3rd consecutive quarter of GDP decline, I could see the Fed considering a pause. However, I think if they do decide to pull back with hikes, it might just the pause in inflation might just be temporary, kind of like what kept happening in the 1970's until Volker raised it by another 9-10% to squash it for good.
@figuy1 Yea I am reluctant to put together a logical case for what the Fed SHOULD do and place a big bet on that, because obviously the Fed doesn't always make the right decisions. See 2021 for a contemporary example. I could make the right decision thanks to my *superior economic analytical skills* and still be completely wrong about what decision the FOMC will make.
Speaking of base years, the Fed could be operating under a theory of inflation where the increase in money supply around the pandemic created a one-time inflation event, sort of like how share dilution has a one-time effect on the price of a share of stock.
They would never talk about such a theory, but if the FOMC believed the theory they would be looking at the monthly numbers for exactly the kind of 0% CPI growth we saw in July and calling that the turning point. If that turning point could set in before inflation expectations solidified, you could defeat 9.1% inflation without raising rates enough to trigger a recession. Then you retire to the halls of the economics gods who turned around impossible situations with the necessary policy innovations like Volker and Bernake.
It's a wishful story, but it kind of ignores the fact that for inflation to stop, somebody has to be the bag holder - i.e. the first person in a web of supply chains to not raise their prices. For every product and service, even commodities production, you have a supply chain and employees, and each of them have seen their costs rise. Inflation is a steady stream of economic actors facing increased costs and therefore deciding to raise their own prices in response. To not raise their own prices in response would require something like employees accepting permanent reductions in their standard of living or investors accepting losses. Usually recessions or high interest rates break the chain and force lower standards of living on everyone (in an uneven way, but lower nonetheless), but we're not yet to the bargaining or acceptance phases yet. We're still living in hope of a miracle: a 2.5%-4% FFR beating 8%+ inflation.
@chris-b Yeah agreed on all points.
I think it's going to take a demand shock to finally bring inflation down. Most likely in the form of higher unemployment rates.
Even if gas prices come back down, people will just use the savings to buy up other things instead to avoid "prices going up in the future".
Politicians don't seem to be interested in doing anything fiscally to bring it down either. Writing off up to $20k in student loans for families making a quarter million dollars per year and the huge energy efficient appliance subsidies aren't going to help the issue either.
@figuy1 I think this sentiment is exactly why we have the difference in the two paths: the FOMC with the higher path and the FFF lower.
But be careful: It's not enough for the inflation rate to come down slightly for a few months due to energy and food and still stand at 5%+. As long as the PCE core is still strong the FOMC might raise rates until the real rate is positive, so the interest rate will have to cross the PCE core. That will not happen if the FFR merely stays at 3.8% for a few months.
But I certainly wish for everybody's sake that the FFR curve is correct and I'm worried for nothing...
@earlyretirementnowcom recent Fed comments seem aimed at traders with the consensus assumption that rates will rise to 4% or less, hold that level, and then be cut when the recession starts in early 2023. They're saying they will not repeat the mistake of 1970, when rates were prematurely cut and inflation prematurely declared defeated, even if there is a recession. Presumably, what is being communicated is that rates will be at least 4% on January 1, 2024, regardless of what hits the fan in 2023.
The FOMC is trying to manage rates on longer, steadier timeframes now, measured in years instead of months, specifically to avoid the sort of trend identification mistake that happened in 1970. "Average Inflation Targeting" was being communicated as a strategy long before the pandemic.
The market's reaction this week has been "Ha! Good bluff Powell! Maybe the bluffing will drive down inflation expectations. Buy stocks!"
But behind the scenes the FFR futures have started to reflect low but growing chances for 4.5% rates this summer. I think the next step is that markets will contemplate the depth of a recession in which rate cuts might not come to the rescue, and we endure agonizing months of the FOMC waiting for more data like they were doing about inflation in late 2021 through early 2022.
Markets should be thinking ahead to the bargains that will appear in the inevitable recession, but instead they've historically tended to rally right up until the recession wipes everybody out. If you're playing musical chairs, maybe carry around your own chair in the form of limited-loss option positions!
@chris-b Most recent FFR futures now signal a 4.7% peak in the rate by mid-2023.
This would have been a good trade.
I personally think the Fed might even go above 5%, so there might still be some juice in that trade idea.
@earlyretirementnowcom The 6.5% FFR and 8% mortgage rates from 2000-01 definitely seem possible if they really want to squash this stubborn inflation.
@figuy1 The current forecast on one site I follow is for 7.7% mortgages by May.
This whole dynamic keeps happening in 2022, where what used to be considered possible becoming the forecast, and then the forecast becomes the reality. Juicy yields are coming our way soon.
@chris-b Wow 7.7% would kill housing prices. What do you mean by juicy yields are coming?
@navypack I mean that if mortgages are yielding 7.7%, then lots of IG corporate debt and preferred stock will also be yielding in the 7-8% range. Also as common stocks get cheaper, their dividend payouts as a & of price will grow. These higher yields will justify more conservative AAs and less of a growth tilt than previously made sense.
Of course, to participate in the fun, one must not lose their money between now and then!
@chris-b Thanks for the link! Eyeballing that forecast (currently at "only" 7.10% (not 7.7%), that seems like a reasonable forecast considering the potential future hikes in the FFR.