On Tuesday the NFIB released its Small Business Optimism Index. According to the website, the indexed “collapsed in November, with a drop of 1.3 points to 94.8 after 3 stagnant months.” It’s the lowest reading of the year except for June, which printed 94.1. Economic data has been mixed. ISM Manufacturing printed 48.6 this month, indicating contraction. ISM Services, while showing growth at 55.9, was still weaker than the 58.0 level that was expected. One might wonder how the Fed can be contemplating a hike in the Fed Funds target given recent news.
Well, the Fed is going to hike next week. The employment reports have been strong enough to provide the Fed an excuse for ‘lift-off’; the last 12 non-farm payroll numbers average 220k jobs added per month. One might argue that the extraordinary plunge in commodities, widening cracks in the high-yield market, strength in the US dollar and related slide in the price of oil would stop the Fed. One would be wrong, at least for December. Yellen et al. have guided the market to price in a hike, and the front Eurodollar contract, EDZ5, has done exactly that, trading at 99.48 (a yield of 52 bps) as of Tuesday. Early in the year, before a hike was contemplated, the March 2015 Eurodollar contract (EDH’15) settled at 99.73 or 27 bps. So now, the EDZ’15 contract is exactly 25 bps higher. The Fed would now risk creating volatility if it DOESN’T hike. In a world of negative rates (even Canada’s Central Bank head Stephen Poloz today opened up the possibility of negative rates on the North American continent), the Fed is anxious to get a more normal positive rate.
The question now is how much the Fed is going to hike. The spread between EDZ’15 and EDZ’16 in Eurodollars is 64 bps, so the market is saying 2 to 3 more 25 bp moves in a year. Option strategies in Eurodollars over the short term are focused on 25 bps at every quarterly meeting. As I mentioned above, when there was no expectation of a rate hike, near Eurodollar contracts settled just under 9975. With an expected hike in Dec the contract is just under 9950. In March, June and Sept contracts, the biggest put open interest is in the 9925, 9900 and 9875 puts respectively, as players have utilized long put butterflies to target moves. I.e., if the Fed were to hike again in March and then in June, one would expect EDH’16 to settle around 9925 and EDM’16 around 99.00. An example of trades that have been placed is EDM’16 9925/9900/9875 put butterfly. This settled at 8.75 with futures at 9916.0. The max loss is the amount of premium paid up front; max gain is exactly at the center strike where one would make 25 bps less premium paid. Break evens are 9916 and 9884 (assuming 9 bps for the butterfly). One might conclude that the option market is forecasting one thing and the futures calendar spreads something else. But the odds on the options markets make both views compatible.
Interest rate futures are comfortably priced for the initial hike. Does that mean that there won’t be volatility in stocks, or more pressure on high yield spreads and commodities? No. Now the trick for the Fed is to convince the markets that the rate hike trajectory will be very, very gentle and gradual. If the Fed muddles its communication, then risk assets could still see violent lurches.
Learn more: Alex Manzara www.chartpoint.com
