Executive summary

Veteran institutional trader Rich Excell discusses inflation risk and examines both a Eurodollar and SOFR option strategy for anticipated market conditions:

  • Bearish risk reversal using Eurodollar options
  • SOFR call spread to express a bullish view

The story for the past 12 months clearly has been inflation. A year ago, we debated whether inflation would be transitory or not. You heard about ‘base effects’ caused by lapping depressed prices from early 2020, and once we were past those, inflation would drop.

However, the concern about inflation was clearly elevated versus any time in recent memory. A quick Google trends search shows how the number of searches on the topic increased last year.

Figure 1:

In spite of this concern, the Federal Reserve was not blinking. There were some market expectations that the discussion about quantitative tightening and the removal of the incremental accomodation would occur at the Fed’s Jackson Hole meeting in late August. However, there was no discussion in the press conference after the meeting. In fact, it wasn’t until November that Jay Powell told us to forget about the word ‘transitory.’ The market has taken that to heart.

Using the CME Fed Watch Tool, we can observe the number of rate hikes priced into the Fed Funds futures curve. Looking at the projections for the December 2022 meeting, the first bar represents the probability that rates are still unchanged, while the sum of the remaining bars represents the probability of at least one hike at or prior to this meeting. It should be no wonder that risky assets are struggling.

Figure 2: Cumulative Rate Hike Probability to December 2022

Example: futures replacement strategy

What is a portfolio manager to do in this case? Looking at CME Group’s contracts, we know that one of the most common hedges for interest rate exposure for portfolio managers are Eurodollar futures. In my career, I know we have used them to hedge option portfolios, convertible bond funds and credit strategies. Typically, because these managers feel their alpha comes from areas other than taking an interest rate view, the futures hedge is applied, often in a systematic way to a year-end maturity. You can see from the graph in Figure 3 , the December 2022 futures has been under quite a bit of pressure this year, as traders reflect more rate hikes and portfolio managers put 2022 year-end hedges on their portfolios. However, are futures the best way to hedge?

Figure 3: Eurodollar December 2022 futures contract

In addition to the fall in futures, the premium for put options on the futures contract is not quite as high relative to calls as it was. This ‘skew’ tended to favor the puts when rates were expected to stay near zero for a long time, the speed of the move lower in futures has softened the skew, with now some concerns of a move in either direction. Using the QuikStrike Vol2Vol tool, we can view the range of option premium for the EDZ2 contract in the distribution on the chart. The red line drawn through gives us a visual of the relative volatility levels. One may consider replacing their futures hedge with a risk reversal options trade, where the trader buys the December 98.0625 put at 12 on an 82 vol and simulataneously sells the December 98.9375 call at 12 on a 77 vol, exiting the short futures position at the same time.

Why would a trader do this? If futures continue lower, they still have the same delta exposure for their portfolio and, therefore, the same portfolio hedge. However, if futures bounces higher from here, as long as it stays below 98.9375 at expiration from the current level of 98.53, the trader will not have any losses on their hedge as you would if you kept a short futures hedge. Above the strike of the call, they would have losses, but they would with their futures hedge anyway. The chart shown in Figure 5 shows the P&L of the options strategy in blue and the expected P&L of the futures position in red. In purple, you see the strategy P&L in 60 days. This shows that until expiration, this options strategy will behave exactly like the futures. The potential benefit comes at expiration if futures prices are higher than here. This is simply a way to attempt to use the options market as a way to gain valuable basis points in relative performance, something all fund managers need to do.

Figure 4 & 5: Eurodollar December 2022 Vol2Vol and projected P&L

Example: Tactical bullish trade

If we consider the situation another way, a trader may want to look at these market moves and think more tactically. Looking at other parts of the rates markets, while the Fed rate hikes are seen, so are the effects of these hikes. The yield curve, measured here by the 10-year Treasury yield less the 2-year Treasury yield, has flattened meaningfully the past six weeks. Perhaps the market is saying the Fed will have to act aggressively and that this will slow future growth. The yield curve is closely watched because it has successfully predicted every recession for the past 50 years, albeit with some variability in the lags. It is not inverted yet, but as you can see from this chart, if it does invert, even by a few basis points, recession will likely follow sometime in the next 6-18 months. The green line in Figure 6 is the NY Fed Recession Probability Index, which is actually falling right now. Thus, one might suggest that while the bond market sees higher odds of a recession, other markets may not.

Figure 6: 10-Year, 2-Year Yield Curve

2022 into 2023 is a period when the market will be transitioning from LIBOR to SOFR. Therefore, traders may want to consider ideas in the SOFR futures and options market. Seeing the yield curve flatten, perhaps the view is that the Fed will have to back off from its hawkish stance at some point this year, and the market will price in fewer rate hikes. It will not happen imminently, but will happen sometime this year. Further, a trader may look at the spread between the June 2022 SOFR futures and March 2023 SOFR futures and see that it is almost two standard deviations away from the mean over the last 12 months. This gives you an idea of how to express a bullish view on SOFR futures.

Figure 7: SOFR June 2022-March 2023 futures spread

In this example, we buy calls on the SOFR March 2023 futures, expecting fewer hikes priced into the market, and therefore higher futures prices. Howevever, given the magnitude of the moves the past few months, the trader would like to reduce to premium outlay and therefore look to do this by selling a June 2022 SOFR call to finance the purchase. The trader could use a similar strike in each tenor in case there is some event that causes the entire futures curve to move higher together. Their thought is that if this does happen, the underperformance of March 2023 vs. June 2022 will cause a larger move higher in the back date. However, if they are correct and the Fed embarks on its hiking strategy but feels that it must end it sometime this year due to weaker data coming in, the June 2022 call could well expire worthless while their March 2023 call moves into the money.

Using QuikStrike’s Spreadbuilder, we can look at the option Greeks from a package in which we sell the June 99.375 call and buy the March 99.25 calls. We are able to reduce the cost of our March calls by 2/3 by selling the June calls. Yes, there is more risk to this spread than there is to an outright call purchase. However, over the last 30+ years, Fed hiking cycles have never been one and done. Thus, if the Fed embarks on a rate hike in March, it is not unreasonable to expect a further hike in May and/or June before the data could possibly change its mind. Thus, the risk on that June call may not be as bad as the model would suggest it is using a more normal distribution of returns.  This trade is not for the faint of heart. It is a counter-trend idea, premised on a Fed policy error. However, if you share this view and can take this risk, the rewards could be appealing. All trades involve risk, we just want to attempt to maximize the reward to risk ratio.

Figure 8: SOFR call spread

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