Executive summary

In this report, Rich Excell discusses the recent November Fed decisions and considers where terminal rates could be in 2023. With the recent Fed moves in mind, he looks at probabilities for future rate changes and proposes an options straddle position to make use of these market conditions.

All eyes have been on the Federal Reserve and short-term interest rates for the better part of the year, but certainly in the last few months into and out of the Jackson Hole Symposium. The November meeting of the FOMC did not disappoint those who expected volatility from the day.

What stood out to me was the Fed saying they still have awhile to go when it comes to raising interest rates, and they will ensure financial conditions are tight enough to bring economic activity and inflation down.

If you look at the chart below, the white line is the Fed Fund rate and the blue line is the financial conditions index, which is still lagging Fed funds but is already up above where it was in the Covid-19 sell-off. Financial conditions are tight, but Chairman Powell has indicated that he wants to get these conditions to get a lot tighter.

Figure 1: Fed Funds Rate, U.S. financial conditions, forward earnings yield, and credit spreads

What are some of the drivers that impact financial conditions? Riskless interest rates, foreign exchange levels, equity valuations, and credit spreads. We know short-term interest rates have tightened. The 75 bps move at the November FOMC was a record fourth for the year. As for the foreign exchange market, the move in the dollar this year has been one of the largest on record. Combined, these two measures are a reason that financial conditions are already extremely tight.

Are conditions tight enough for the Fed? If you look at the orange and purple lines, they stand out to me. The orange line is equity valuations. Here I am looking at the forward earnings yield of the S&P 500, which is the inverse of the forward P/E ratio, to put it in yield terms. In order to get to where the earnings yield is equated with the current level of financial conditions, a move to a forward earnings yield of 7.5% is needed. That suggests a 13x P/E. Perhaps the FOMC thinks it could even be lower. This potentially brings in a new left-hand tail that the market may not be fully pricing in.

Potentially, even more out of alignment are credit spreads, which is the purple line, and credit spreads (calculated with Moody’s Corporate Baa less 10-year US Treasury yield) is only at 2.1%. This alone leads to a very high absolute level of corporate interest rate in excess of 6%. However, if this spread just goes back to where it was in Covid-19, that would be 4%, which added to a 4.25-4.5% 10-yr is 8%+ Baa corporate debt yield.

All of this suggests the cost of capital, both equity and debt, is set to move higher. Put into the weighted average cost of capital calculation and used in an investor’s DCF model, one must conclude that net present values of investments look a little worse post the November FOMC meeting.

This begs the question of how much further do the Fed Funds have to go? What is the terminal interest rate for Fed policy? If we use the Bloomberg WIRP function, we can see that prior to the November 2 meeting, the terminal Fed Funds rate was thought to be about 4.75%. It was thought we could get there by March of 2023.

Figure 2: Interest Rate Probability in the U.S.

If we look at the days after the November FOMC meeting, we can see that this terminal value for Fed Funds had moved up to 5.10%. Not just higher, but higher for longer as the market does not see us reaching that level until June and sees us above the previous peak of 4.74% into 2024 now.

Figure 3: Interest rate probabilities in the U.S. post November FOMC meeting

Turning to the Fed Watch Tool on the CME Group website, we can visualize how the Fed Funds rate expectation for the December meeting has moved from a 50-50 of 4-4.25% and 4.25-4.50% in September to 4.25-4.5% and 4.5-4.75% post the November meeting.

Figure 4: Target rate probability for December FOMC meeting

If we look at these levels and probabilities for the February FOMC meeting, we can visualize the 4.75-5% now garners the highest probabilities.

Figure 5: Target rate probability for February 2023 FOMC meeting

While both of those visualize the odds of certain rate levels, we can see it in a bar chart too:

Figure 6&7: Target rate probabilities for December and February FOMC

One thing you can see from this clearly in image 7 is that the market now assigns a greater than 30% probability of Fed Funds being higher than 5% by February of next year. In this sense, the market is now getting even more hawkish than the FOMC itself. How can I say that considering the comments by Chairman Powell? I am referring to the FOMC Dot Plots by which the FOMC attempts to communicate where it sees the terminal level of Fed Funds rates. We can see that the dots from the FOMC for 2023 cluster below the 5% level, approximately in the ~4.75% range.

Perhaps many in the market are looking at similar charts and are extrapolating a conclusion of a much higher Fed Funds rate than the committee is thinking. Maybe we are all getting too bearish?

Figure 8: FOMC Dot Plots post the November FOMC meeting

In fact, if we look at the probabilities being priced into the Fed Funds futures market for the 2023 meetings, we can see several instances where the market sees the possibility Fed Funds futures are above the 4.75-5% range that are the peak of the FOMC dot plots. This could suggest that the downside of the Fed Funds futures market might be getting ahead of itself relative to the FOMC itself.

Figure 9: Target rate probabilities

As we can see over the course of the year, as the Fed has hiked the Funds rate, we also see the spread between SOFR and Fed Funds becoming more positive, even if it has been a little bit noisy. This is true in both the One-Month and Three-Month SOFR futures vs. Fed Funds.

Image 10&11: Figure 10 and 11: SOFR vs. Fed Funds in One-Month and Three-Month

We can see from the CVOL tool that volatilities are still near the highs of the last one year even if these volatilities are off the most extreme levels of the year.

Figure 12: CVOL for STIRs last 1 year

You can also see that the same volatilities are near the lowest levels of the last three months even though we might be moving into the most uncertain part of the Fed hiking regime. For the better part of the year, the market may not have known quite how much the FOMC would hike, but it knew it would at each meeting. Now, the market has one view of terminal Fed Funds, and the dots plots (and FOMC dissenters perhaps) may have another. The possibility for a surprise in outcomes seems to be growing potentially.

Figure 13: CVOL for STIRs last three months

We have watched implied volatility fall for the past six months along with the futures even though the historical volatility for the same contract has been relatively flat for the past three months.

Figure 14: 3m SOFR Implied vs. Historical volatility

Positioning in the Three-Month SOFR future has become less short since the middle of the summer but is still net short.

Figure 15: 3M SOFR futures positioning of leveraged accounts

Taking this into account, I can come to some conclusions based on what I see in the information above. First, even if volatilities have declined recently, the level is still relatively high on a one year basis, primarily because historical volatility has stopped declining. Second, positioning has gotten less short among leveraged accounts in the last few months. Though this positioning is still short and may be trying to identify the Fed pause or at least when the market has priced in all the Fed moves. Third, the levels priced into the futures market go beyond the FOMC dot plots, which may indicate the market is getting ahead of the curve here. Finally, as the rate hiking occurred, the spread between Fed Funds and SOFR has moved closer to zero.

In my opinion, one way to take advantage of this accumulation of news is to sell the March 2023 95.00 straddle in SOFR. This is slightly higher strike than the ATM. I suggest you cover the downside tail by buying the 94.75 put. Yes, this leaves you somewhat exposed on the upside wing, but this does not seem to be where the market’s fears are right now based on the positioning and the probabilities of what is priced in. If the FOMC decides on a pause in December or even February, the probabilities of a move lower are reduced, and volatilities should fall further. It is unlikely we see the Fed pivot many have suggested and thus you can take advantage of higher implied volatilities to capture some premium while being covered on the riskier tail.

Figure 16: Short SR3H3 95.00 straddle with a long 94.75 put

One can see that a trader using this approach would make money on a futures settlement anywhere above 95.29, with profits maximized on a settle at 95.00. The risk to the trade would appear to be any exogenous shock that may require a sudden pause in the rate hiking cycle. While this is clearly possible, one might think it is unlikely to occur before the December meeting at which time rates appear to be headed to 4.25% if not 4.5%. Putting on risk around inflection points can often seem like the riskiest time to have a view; however, if structured properly, it can also yield some very attractive breakeven type of ideas.

Good luck trading.

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