As the Fed navigates high inflation, how can traders can use the new SOFR mid-curve options to express their opinions? In this report, Rich Excell looks at the new SOFR mid-curve options to express a contrarian FOMC view relative to the market.
This year has been nothing if not volatile and confusing even for the most seasoned of traders. We started the year with the market starting to think the Fed may be finishing the rate hike cycle, at the same time CPI was calming down. This “Twin Peaks” of Fed hawkishness and inflation led to a risky asset rally at the start of the year. The FOMC responded by upping the ante on hawkishness in February, leading the market to price rate cuts out of the curve and to extend the pause date. Risky assets responded in kind, struggling all through February. We moved into March and hit a low with the problems at banks. As a result, the FOMC was seen as more dovish in March, leading to the same risk asset rally into the end of March that we saw at the start of the year. We had come full circle. As we look at the market expectations going forward, we can see there is roughly a 50% chance of a hike in May but then expectations of cuts starting in July and growing the rest of the year.
Image 1: Probability of a rate move at FOMC meetings
If we compare the Fed Funds futures to the FOMC dot plots, we can see that the market is much more dovish than the FOMC itself. Of course, some would argue that the FOMC cannot be as dovish vocally as it may be behind the scenes, given it must remain vigilant on the inflation front. However, while the majority sees a pause, the granularity of the dots for this year suggests that if there is a dissension at all it is for higher and not lower rates. Only one member sees lower rates in 2023. Does this suggest that the FOMC just needs any small excuse to continue on the path to higher rates? It was only a month ago when some expected the terminal Fed Funds rate to have a six handle.
Image 2: Fed dot plots vs. Fed Funds futures
The lingering question has been, “where are we on the inflation front?” This has been the market concern for two years as we can tell from the positive correlation between stock and bond prices. If the market were concerned about growth, these assets would revert to the negative correlation exhibited in the entire post-GFC through 2021 period.
Where do we stand on inflation? In the latest ISM prices paid, we see the measure continue to fall. It has had a good lead over the headline CPI and PPI data, suggesting we could continue to see a disinflationary impulse in the months ahead.
Image 3: ISM prices paid vs. PPI and CPI
Looking through the components of inflation, we can see that food prices have been a big driver of disinflation. I look here at the UN Food Price Index in pink, but also the CPI fresh foods component in green, and the CPI processed foods component in blue. CPI headline is in yellow, and you can see it is impacted by these prices. It is interesting to me to see the disconnect between fresh and processed food, with the latter driven as much or more by human capital costs (marketing) as the input costs.
Image 4: Food inflation
Another concern for consumers and businesses alike is the energy component. We can see in the U.S. that in particular natural gas has fallen considerably for the better part of nine months. A warmer than expected winter has led to excess storage of natural gas and a fall in prices. Oil and gasoline have also come off the highs but have started to find a floor here. With the latest headlines that OPEC+ is cutting one million barrels per day, perhaps we have seen the extent of the disinflation from oil and gasoline. For better or worse, gasoline prices are the one number all consumers have a good sense of and may play a disproportionate part in the wage negotiation process.
Image 5: Energy inflation
Another place to consider is housing. The CPI housing component in yellow, owners’ equivalent rent, has remained stubbornly high. However, if we look at the yearly change in the Case-Shiller U.S. National Home Price Index, or the yearly change in the Zillow National Rental Index, we can see both would suggest a fall in CPI OER is forthcoming. These indices have led by about a year in the past, which could suggest a fall in CPI OER this summer and through the end of the year.
Image 6: Housing inflation
If we go back to the finished goods inflation – CPI, PPI, ISM Prices paid – and look at the overlay vs. the SFR mid-curve futures (inverted), we can see maybe some reason to expect higher futures prices (lower yields) if this is the focus, which I would argue it is for many.
Image 7: Finished Goods price inflation vs. SRAA (TS2)
However, I feel that the FOMC is more worried about inflation expectations. Inflation is not just a number, but a mindset. When consumers become worried about inflation and persistent inflation, they begin to ask for higher wages. This is how what was thought to be exogenous or transitory inflation can become permanent. My sense is the FOMC is fighting hard, with rate moves and commentary, against this inflation mindset. On this chart, I put the NY Fed 1-year inflation expectations in white, which has been falling but is still well above the 2% target at 4.2%. I also include the University of Michigan inflation expectations in orange, which you can see had been falling but is turning back higher. The last line in blue is the SRAA (TS2) future inverted.
Image 8: Inflation expectations vs. SRAA (TS2)
We can see these inflation expectations impacting wages. On this chart I show you the employment cost index in white vs. the Atlanta Fed sticky inflation measure in blue. The higher employment costs are a driver of this sticky inflation, which the FOMC has been particularly worried about. Again, I overlay SRAA (TS2) in orange to show that the level of futures has been more closely aligned with this sticky inflation. If consumers are still demanding higher wages, will the FOMC be more hawkish than the market expects? The market is expecting cuts. What if the Fed is just on permanent pause, in other words, higher for longer?
Image 9: Employment Cost Index and Atlanta Fed sticky inflation vs. SRAA
What has been driving the Employment Cost Index? It may be the undersupply of labor. I compare the ECI yearly changes to the Job Opening and Labor Turnover Survey (JOLTS) data. I also include the Atlanta Fed sticky core inflation, which may be more indicative of what Chairman Powell is referring to when he says core, ex-housing services inflation. We can see that the JOLTS data fell this week from a shortage of 10.5mm (revised) workers to 9.9 mm workers. Perhaps this is because workers are starting to take these jobs, or because these jobs are being pulled. However, as you can see, even this 9.9mm number is more than 30% above the previous peak we saw in 2018 so it may be too soon to suggest that the ECI and the Atlanta Fed sticky core will move considerably lower. Does this still suggest the odds of a Fed cut this year are lower than the market thinks?
Image 10: Employment Cost Index and JOLT Survey
If I then compare the SRAA (TS2) futures curve, in orange, between now and only one month ago, in green, we can see that meaningfully lower futures prices were expected across the curve just one month ago when the market was not focused on the Fed pause and then cut but still on higher for longer. What if the market reverts back to this mindset?
Image 11: SRAA futures curve
An advantage I can see for the mid-curve monthly options is the ability to take a view at the right part of the implied volatility term structure. I may be inclined to go out to September to express my contrarian view above given that is where the pivot in the futures market is. However, we can see that this is the most expensive implied volatility this year. June options are depressed relative to both the May and September dates. What if I could buy a June option on a September future? I would get the leverage of the options, at a lower June implied volatility, with the ultimate impact coming from the September future, a time by when the market may have changed its view.
Image 12: Implied volatility term structure for SOFR options
Overall, in SOFR options we can see a preference for calls over puts. Given the sharp moves driven by hedge fund risk reduction we have seen in the STIR market on the back of the changing view in FOMC policy, this should not be surprising. However, this may be something we can take advantage of to express our view.
Image 13: Vol skew for SOFR options
Given that I am able to buy options at a level of implied volatility that is lower than the periods around it, I do not mind being net long options. I also like the idea of convexity in the trade/portfolio given the rapidly changing nature of market views around FOMC policy. I want to use the TS2M3 options and take advantage of both the options market favoring calls and the futures market being fully priced for cuts that I do not think are coming. I understand there is open-ended risk to selling calls here yet given that I believe consensus is solidly on the same side of the boat in regards to rate cuts, and if any surprise occurs, comes from higher for longer, I feel the risk reward of this trade is quite attractive. I will need to be very aware of the data and risk manage this closely.
Specifically, I have used a ratio risk reversal where I sell one of the 95.5 calls and use the premium to buy two of the 95 puts. I am net spending some premium, but again, I do not mind being net long convexity. My risk at 95.5 is that the Fed does in fact start to cut before September. This is a risk I am comfortable taking given what the market is pricing in.
Image 14: Expected return for a TS2M3 95-95.5 ratio risk reversal
These are the Greeks for the trade. You can see that as I am a little more OTM on the puts, the volatility is slightly higher, however, the total skew is not that severe. In addition, I am buying options on a 113 volatility, which is quite low relative to the rest of the curve.
I clearly have Theta risk in being net long options. However, I benefit from being net long Gamma, Vega, and speed, all of which I think are important for traders in this market.
Image 15: Option Greeks for the ratio risk reversal trade
CME Group continues to find products that enable traders to customize their views more and more. This week I look at the new SOFR mid-curve options to express a contrarian FOMC view relative to the market. The fact I can use June options on the September future gives me a lot of flexibility in how I express this view.
There is open-ended risk that a trader must manage, however, for those looking to take a bit of a contrarian view on the recent market action should look no further than TS2 options.
When it comes to your trading and risk management…stay vigilant.
Understand monthly SOFR Mid-Curve options
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