Report highlights

Image 1: Monthly CPI year over year vs. CPI custom forecast index overlaid with Federal Reserve Target Rate

When it comes to the expectations of FOMC policy this year, I believe the discussion has come down entirely to one’s views on inflation. Whether, and how aggressively, the FOMC will cut rates revolves around this inflation discussion and not growth. Why do I say that? Based on a recent Wall Street survey, 75% of investors see a soft landing, 20% see no landing at all and only 5% see a potential for a hard landing. While this may be fodder for another Excell with Options in the future, I think it is safe to say the market right now is not worried about growth. Thus, the debate on the future for the FOMC must come down to inflation. 

I have built a custom index in Bloomberg, which I call CPIFCAST for CPI forecast (white line). It is a geometrically weighted index that uses the five most common variables students use when building economic models in my class to forecast inflation (they also forecast growth, but the commonality of variables isn’t as high interestingly). The five variables I see the most are financial conditions, inflation expectations, commodity prices, PPI inflation and M2 money supply. I created this index so I could show my classes that it is possible to find a group of variables that usually do a pretty good job of tracking inflation (as measured by CPI blue line). The problem of late is that while this index has historically done a nice job, it has become very dislocated from inflation for the past 12 months. The rapidly falling CPI has many in the market expecting this to continue, which is expected to lead to a move dovish FOMC going forward. Both the CPIFCAST and CPI data has historically led the Fed Funds Target Rate over the past 10 years. The difficult part right now is whether one should trust their model and expect basically no rate cuts, or trust the headline data, which would likely lead to a much more dovish outlook. 

Image 2: FOMC Dot plot vs. Fed Funds futures as of the December meeting and currently

If I look at the FOMC Dot plot in Bloomberg, which puts the median FOMC dots per the past meeting in December, I can see how the market has decided to respond to the news. The market appears much more dovish than the FOMC, which itself is forecasting rate cuts this year (three), just not as many as the market is forecasting. When the dots first came out, more than six rate cuts appeared to be priced into the curve. I calculate this by looking at the difference of current rates (5.33% mean) to the rates at the end of 2024 (3.88%) and assuming 0.25% move per meeting. The green line above shows the median FOMC dot, which shows the three rate cuts. The blue line shows where the market was in December, much more dovish.

I can also use the CME FedWatch Tool to see the probabilities of a move at each of the meetings this year as determined by the Fed Funds options market. Based on this table, I think the probability of a cut at the June, July and September meetings is higher than 50%, and I think there is a slightly lower probability of cuts at the May and November meetings.

Chairman Jay Powell took to both the press conference after the January meeting, as well as to “60 Minutes” a few days later to caution the market that the FOMC may not be as dovish as it is expecting. The short-term interest rate market has responded somewhat. I can see current values in white, which has made back not quite half of the disparity between the market and the FOMC. 

In March of this year, we will also get a new FOMC dot plot, because this year we have some members that are no longer voting, while there are new members who have become voters for 2024. In 2023, there was presumed to be a slightly more dovish lean to the regional voting presidents with Goolsbee from Chicago, Harker from Philadelphia, Logan from Dallas and Kashkari from Minneapolis.  In 2024, these voters have moved on and the new voters among regional presidents are Barkin from Richmond, Bostic from Atlanta, Daly from San Francisco and Mester from Cleveland. By most accounts, this group collectively leans slightly more hawkish. 

While the decision at each meeting will in fact be a consensus-building exercise, I highlight this change in voters because it potentially could lead to a shift in the dot plots, which may be a catalyst for some in the market to change their own outlook about the path of rates in 2024. 

Image 3: Consensus expectations in the SOFR market based on FOMC rate decisions

In order to get a sense of what the market is anticipating and what this means for the SOFR futures market, I turn to the relatively new CME SOFRWatch Tool. As a reminder, I want to understand that the interest rate implied by the SOFR futures market is 100 – futures price. For example, a futures price of 94.69 in March of 2024 would imply the market sees interest rates at 100-94.69 or 5.31 at that expiration. 

Now, back to the SOFRWatch Tool. Per the CME Group website: “CME Group has developed a tool to help clients visualize the potential impacts of the Federal Open Markets Committee (FOMC) decisions on the expected prices of SOFR futures. By allowing users to input their own expectations of what the Fed might do in upcoming FOMC meetings, this tool provides a view of where CME Group SOFR futures prices could settle if the user’s expectations prevail.”

Bringing up the tool and looking at the default settings, there are a couple things I can see. First, I see the default spread between FOMC and SOFR, which is set to six basis points. If a trader has a strong view that this should be different, they are free to change this setting. Second, the SOFRWatch Tool utilizes the implied probabilities on the CME FedWatch Tool (using Fed Funds futures prices) as a baseline and allows me to override what I think will happen at any given meeting. By default, the pre-populated values are the most likely rate path as informed by the FedWatch Tool. By means of this, I can see the five rate cuts priced into the market for this year: May, June, September, November and December. This functionality quickly allows me to establish what consensus estimates are for the coming year.  

Image 4: CME SOFRWatch Tool updated to include my personal forecasts

The nice feature of the CME SOFRWatch Tool is that I can input my own forecasts for what I anticipate happening and see the potential impact on the predicted SOFR futures curve. This predicted curve is then overlaid vs. the actual SOFR futures curve for me to see where there is an opportunity for an out-of-consensus trade to potentially do. 

I am going to rely on the CPI Forecast model I have built because it has served me well through the years. As I showed in the picture at the start of the write-up, this would lead me to be much more hawkish than the market. As I see it, there are three scenarios for the market this year: 1. Soft landing and rat cuts (consensus view) 2. Soft landing and no rate cuts (my view) 3. Hard landing and rate cuts (out of consensus view).  In fact, I think that because of the soft landing in the economy, there is a risk that inflation re-ignites, as we saw in the 60s, 70s and 80s. This is what my model says, with inflation expectations and financial conditions as the big drivers of higher forecasts. I would also add that I think the FOMC will be very hesitant to change rates near the election this year for fear of being accused of being too political. 

If I put these views into the SOFRWatch Tool, that is no rate cuts this year, I can see what my personal predicted SOFR futures curve would be vs. the actual. As I do that, the June futures contract stands out to me as the place I want to look for opportunity. Could the March FOMC meeting, with no rate cut and a potential change in the dot plots, lead the market to get more hawkish and change views for the May and June meeting? That would be consistent with the view I have put into the tool here. 

Image 5: SOFR June options volume and open interest

There has been quite a bit of activity in the SOFR options market in April, May and June. If I look specifically at the June options activity in QuikStrike, I can see where the bulk of the volume and open interest are clustering. The futures is at 95.11, and there have been two pockets of volume, in and around the 94.9375 strike as well as in and around the 95.50 strike. 

I want to lean into where this volume is, as it could potentially be a magnet if the futures are near there at expiration. While the view I have put out there is very different than the market, I want to be cognizant of where the market consensus and activity is, knowing that those clustered areas of activity may be difficult to move through. 

Image 6: CVOL for Short-term Interest Rate markets

As always, I want to bring in the CME Group CVOL Tool to get an understanding of where implied volatility is in the SOFR futures contracts relative to its own history. This tool is an invaluable resource allowing me to see how the price I am paying (or receiving) for the options I buy (or sell) compares to a time series of data. I look over the last year because for me that is about the time when the market has shifted from the “FOMC rate hike mode” into the “FOMC pause with a rate cut soon” mode. I think from an implied volatility expectation standpoint, these are different types of market environments. 

As I look at the levels, I can see that the current CVOL levels, for all of the futures, is at or very near the lowest levels we have seen for the past one year, suggesting to me that the expected volatility going forward is quite muted. Said another way, I might say that the market appears confident in the consensus forecast (five rate cuts) of what will happen. For a trader like me that thinks a different outcome might occur, this could present an opportunity for long options. 

Image 7: CVOL and CVOL Skew history for Three-Month SOFR options

I can also plot this data and look at it visually over the last year to see the path it has taken. I can see that CVOL has come down to these levels a couple times in the last few months. Back in September/October when the market was starting to expect cuts after the July pause but was shaken from that view by the FOMC and then again in December when the market was convinced of six cuts after the December FOMC meeting. When the market had to change its dovish view, CVOL moved higher. I can see that as the market changed its view, hedging activity picked up, and the measure of skew moved lower, showing a preference for downside strikes as a means to hedge. If I expect a similar outcome, I see the potential for higher CVOL as well as a continued move lower in skew, with a preference for downside strikes. 

Image 8: Three-Month SOFR futures implied and historical volatility

As the saying goes, “price is what you pay, but value is what you get.” By this, I would suggest that a low CVOL is the low “price” but is it value? For me to consider that, I have to look at the level of implied volatility and compare it to the level of actual or historical volatility. This is the volatility I will experience, that will allow me to delta hedge my position should the directional view not play out. In addition, if historical volatility stays persistently above implied volatility, market makers will slowly move their price for implied volatility higher knowing they can make back their nightly theta or time decay. I can see in the chart above, implied volatility has been trending lower, but over the last several weeks, historical volatility has picked back up. This indicates a disconnect between what the market thinks will happen and what is happening. The author/trader/teacher Shelly Natenberg likes to say that volatility is like the weather – it has a serial correlation component and a mean reversion component. Tomorrow’s weather will be a lot like todays. However, over the longer time, volatility will revert toward longer-run mean levels. I could argue that both could argue for higher implied volatility over the next several months. 

Image 9: Implied volatility by delta

I have made up my mind that I want to lean long options because of my expectations that it may be moving higher going forward because of my directional view and evidence this has led to higher prices, because implied volatility looks low relative to historical volatility, and because the CVOL is at its one-year low levels. Now I want to see which options within an expiration look relatively attractively priced. When I bring up the QuikStrike volatility by delta, I can see the market is selling the downside options at implied volatility below the at-the-money, while upside strikes are trading at a premium to the at-the-money. This tells me to focus my purchases in the at-the-money or lower strikes, which is also consistent with my view. If I want to sell any options to reduce my costs, I should try to focus the selling on upside strikes if possible. 

Image 10: Long SOFR options

I have decided to lean into my view as well as the recent activity. I want to put on a directionally bearish view and lean net long options from here. I decided to focus my buying near the 94.90 strike, which, based on its implied volatility relative to the at-the-money, suggests this strike has been sold by other market players. I can buy these options at just below a 72 implied volatility. I prefer to have my direction views to be zero-cost if I can construct it. As we saw before, the upside strikes trade at a premium, so I looked to sell a 95.25 put to make this structure zero cost. By selling one of the in-the-money puts, I can afford to buy three out-of-the-money puts. I am selling an 89 implied and buying a 72 implied. Over the next month or two, my expected return (dashed lines) looks like a long-put option. However, as I near expiration, my P&L starts to suffer and there is a big potential risk if I am at or near strike at expiration. Thus, I look at this idea as one that is focused on the potential catalyst of a March FOMC meeting, but after that, I would want to actively manage the risk of this position and not necessarily ride it directionally all the way to expiration. 

Looking at the Greeks, I am long gamma and vega, but my theta for now is not large at all. I am also long some second order Greeks like vomma and speed, which I like given the potential for a catalyst in the market which could change the consensus opinion of the outcome. 

Image 11: CME SOFRWatch Tool with curated expectations of FOMC rate cuts

The last step for me is to return to the SOFRWatch Tool and play with different possible ideas that could deliver a predicted SOFR that would deliver a price that would end up in my worst case scenario. I want to know what could happen to give me the worst outcome, so if it does happen, I can be very quick to react and trade out of my position. Looking at it, I see that the most likely outcome to get the SOFR futures to settle at 94.90 at June expiration, is no cut in March or May, with a 25-basis point cut in June, but then nothing in the months after. This is a one rate cut scenario, perhaps not entirely likely, but something I want to know would be a bad outcome for my idea. 

Hopefully you can see that the tools available at CME Group can help me determine the consensus views, create custom strategies and anticipate where risks might be in these strategies, so I know when and how to risk manage my positions. 

Good luck trading!

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