Executive summary

With the Jackson Hole gathering of global central bankers happening between the July and September FOMC meetings, the market may anticipate a pivot in Fed policy as growth concerns begin to overtake inflation worries. In this week’s issue, Rich examines a SOFR call diagonal for potential market events.


As we concluded investing in the first half of the year, we note that most of the discussion so far in 2022, for both consumers and investors, has revolved around inflation; however, the story may be changing. More and more consumers, companies, and investors are beginning to worry more about layoffs, inventories, and economic growth. Over the last six to eight weeks, the economic data has continued to disappoint. The Citi Economic Surprise Index measures how economic data has been reported relative to expectations. What it is trying to assess is whether the data is better or worse than expectations. One of the arguments from some market participants was that the economy would slow and bring down inflation with it. That may be happening.

Figure 1: Citi U.S. Economic Surprise Index

Right before the long weekend, there were some important data releases.  The Institute for Supply Managers PMI Index came out before the weekend. While the headline was weaker than expected, it was still above the 50 level that distinguishes between growth and contraction. However, the real story is the data within. Looking at the ratio of New Orders to Inventories, one can get a measure that anticipates where the headline ISM will go. Remember, this ISM headline leads the GDP data and tends to be coincident with the Equity market. Being able to anticipate this data may be helpful. In Figure 2, this ratio is in white, which has been anticipating a slowdown in the headline (orange) for a year. Another corroborating data point is the ratio of copper to gold. Within the commodity market, this is a metal that is linked to economic growth (or contraction) versus a store of value. Again, the ratio may help anticipate the direction of the global economy. This ratio in blue had been holding up until very recently. However, it has now fallen. The last measure overlaid here is the 10-Year Treasury Yield. Historically, it follows all three of these measures.  It has disconnected of late, as perhaps the market (and the Fed) was more worried about inflation. It may be that this is about to change.

Figure 2: ISM and 10-Year Treasury Yields

Most people reading this would probably suggest it’s about time for investors and policymakers to understand the risks of recession. Lately, a popular chart on Twitter is the Google Trends data of searches for recession. This data shows Google users have been increasing for the better part of the last few months and are getting close to the level they hit before the 2008 and 2020 recessions. It would seem the masses may be onto the economy before the experts.

Figure 3: Google searches for recession

The short-term interest rate market is also beginning to be worried about this risk. Looking at the Fed Funds futures market, you can see that the expected Fed Funds future in 18 months is now trading above the Fed Funds future in six months. When this happens, a recession tends to be near. The market is saying the Fed is likely to keep hiking for now, but in early 2023 it will have to start easing because it has gone too far.

Figure 4: Fed Funds future 18 months less six months

This can also be seen by looking at the term structure of the Secured Overnight Financing Rate (SOFR) futures curve. Based on this chart, the rate hikes are priced in for the rest of 2022, with cuts in early 2023. The bond market may be worried that this disappointing economic data over the last six weeks will lead an aggressive Fed into a policy error.

Figure 5: SOFR futures term structure

Yet, looking at the FOMC dot plots to get a gauge for what the central bank itself is thinking, we see that policy makers are much more hawkish and see continued rate hikes not only for this year, but for 2023 as well. It’s possible there is a disconnect between Fed policy makers and the short-term interest rate market.

Figure 6: Federal Reserve dot plots

Looking at the bond market expectations for the July 27 FOMC meeting, we can see that there are 80% odds of another 75 basis point hike. If you look ever so subtly, the odds of 75 bp have been coming down slowly over the last month.

Figure 7: July 27 FOMC meeting expectations

This relative dovishness from the STIR market is a little more apparent when we look at the expectations for the September 21 FOMC meeting. This meeting comes after the Kansas City Fed Jackson Hole Summit (August 25-27), the annual gathering of global central bankers and economists, where policy papers are shared and often where policy changes are communicated. In fact, there are many that think Jay Powell may have missed a chance to be more hawkish at the Jackson Hole Summit last year. Will Jay Powell miss the chance to alter the course this year?

Figure 8: September 21 Fed expectations

Putting this all together, we try to see if there is an opportunity to express a view in the options market around a potential change in central bank posture. The premise is the economic data is catching up to consumer expectations on the downside. Recession fears are rising. If the odds of a recession are rising, it’s possible that inflation may finally start to slow, which means the FOMC may not need to be as aggressive as it has communicated. The big question for investors will be, If there is a change in the mindset of the Fed, will it communicate that change at the next FOMC meeting on July 21? Or will it choose rather to wait for more economic data to discuss more with its peers globally, and to use the podium of the Jackson Hole central bank gathering as the chance to change the course for rate policy going forward?

Looking to the options market, particularly at the term structure of implied volatility in the SOFR market, we can see that the September bucket is the lowest point for implied volatility currently in the market. The expectation for an increase in volatility doesn’t come until after the September expiration. It just so happens that the September FOMC meeting is on September 21, which is after expiration. There are little expectations for the Fed to change its stance ahead of that September FOMC meeting. The August expiration, which is after the July FOMC but before the Jackson Hole meeting, has slightly higher implied volatility. Could this present an opportunity?

Figure 9: SOFR implied volatility term structure

Looking at SOFR September futures, there is a subtle sign of life that hasn’t been present for all of 2022. This year it has been a one-way ticket lower. After getting oversold on the RSI in June, the futures price started to nudge higher, with the MACD (middle panel) turning higher as well. The ‘cloud’ on this picture shows the area where the most volume has occurred over the last two months. This is meant to show the approximate average price where longs and shorts may be. It can represent some potential congestion as prices move higher.

Figure 10: SOFR September futures price

SOFR Call option diagonal example

We have a possibly bottoming futures price that could run into some congestion in the near term. We have few expectations for a big event from the FOMC over the summer if we are looking at the term structure of implied volatility. In fact, there are slightly more expectations for volatility from the July FOMC than the Jackson Hole meeting. In this example, I could sell an August SOFR 97.25 call and use the proceeds to buy a September SOFR 97.4375 call. This trade can be done for roughly zero cost. The Greeks for this spread are also basically neutral at the time of writing. However, you can also see that I’m selling about a 123 implied volatility and buying about a 115 implied volatility. Therefore, I’m maximizing the shape of the term structure of implied volatility.

Figure 11: SOFR call option diagonal

With any diagonal trade, such as this, there are risks. First, if the future price moves above strike in the near term before the short call option expires. If this were to happen, the position would suffer a loss on the difference in strikes. In fact, the gain on this diagonal trade would only occur if the shorter-term option expires worthless and then the future moves above the strike of the call before the next expiration. For many, this may seem to be too nuanced of a trade. However, there may be reasons that we could see this:

  1. Technically, while the futures price may be turning higher after a long period of moving lower, there is some congestion that could slow its rise.  
  2.  The FOMC only recently increased its level of hawkishness, deciding just prior to the June FOMC to move 75 basis points.  
  3. The STIR market is starting to price out very small amounts of hawkishness for the July 21 FOMC meeting.
  4. The Fed and other central banks have used the Jackson Hole meeting to signal changes or major policy news in the past.

If the inflation data persists, and the market as well as the Fed feels more hikes are needed, futures may head lower. However, since this spread is done at or near zero cost, there would be no loss if that happened before the September expiration. If it happened in the next month, there is the possibility that the August option decays much faster than September and the spread could be worth more money. There is also the possibility that the futures price is never above either call strike. This would limit the amount the position may make. Yet, if the futures price stayed stable and implied volatility did not change, this diagonal spread would again gain value from the positive theta of the trade. The biggest potential upside is if there is no change in policy until the Jackson Hole meeting, and the Fed decides to get dovish at that time, getting dot plots more in line with the market that sees rate cuts next year. The odds of this may be low, but the rewards could be quite positive if it were to happen.

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