The story for the past 12 months clearly has been inflation. A year ago, we debated whether inflation would be transitory or not. You heard about ‘base effects’ caused by lapping depressed prices from early 2020, and once we were past those, inflation would drop.

However, the concern about inflation was clearly elevated versus any time in recent memory. A quick Google trends search shows how the number of searches on the topic increased last year.

Figure 1:

Figure 1
Source: Google

In spite of this concern, the Federal Reserve was not blinking. There were some market expectations that the discussion about quantitative tightening and the removal of the incremental accomodation would occur at the Fed’s Jackson Hole meeting in late August. However, there was no discussion in the press conference after the meeting. In fact, it wasn’t until November that Jay Powell told us to forget about the word ‘transitory.’ The market has taken that to heart.

Using the CME Fed Watch Tool, we can observe the number of rate hikes priced into the Fed Funds futures curve. Looking at the projections for the December 2022 meeting, the first bar represents the probability that rates are still unchanged, while the sum of the remaining bars represents the probability of at least one hike at or prior to this meeting. It should be no wonder that risky assets are struggling.

Figure 2: Cumulative Rate Hike Probability to December 2022

Figure 2: Cumulative Rate Hike Probability to December 2022
Source: CME Fed Watch Tool

Example: futures replacement strategy

What is a portfolio manager to do in this case? Looking at CME Group’s contracts, we know that one of the most common hedges for interest rate exposure for portfolio managers are Eurodollar futures. In my career, I know we have used them to hedge option portfolios, convertible bond funds and credit strategies. Typically, because these managers feel their alpha comes from areas other than taking an interest rate view, the futures hedge is applied, often in a systematic way to a year-end maturity. You can see from the graph in Figure 3 , the December 2022 futures has been under quite a bit of pressure this year, as traders reflect more rate hikes and portfolio managers put 2022 year-end hedges on their portfolios. However, are futures the best way to hedge?

Figure 3: Eurodollar December 2022 futures contract

Figure 3: Eurodollar December 2022 futures contract
Source: Bloomberg

In addition to the fall in futures, the premium for put options on the futures contract is not quite as high relative to calls as it was. This ‘skew’ tended to favor the puts when rates were expected to stay near zero for a long time, the speed of the move lower in futures has softened the skew, with now some concerns of a move in either direction. Using the QuikStrike Vol2Vol tool, we can view the range of option premium for the EDZ2 contract in the distribution on the chart. The red line drawn through gives us a visual of the relative volatility levels. One may consider replacing their futures hedge with a risk reversal options trade, where the trader buys the December 98.0625 put at 12 on an 82 vol and simulataneously sells the December 98.9375 call at 12 on a 77 vol, exiting the short futures position at the same time.

Why would a trader do this? If futures continue lower, they still have the same delta exposure for their portfolio and, therefore, the same portfolio hedge. However, if futures bounces higher from here, as long as it stays below 98.9375 at expiration from the current level of 98.53, the trader will not have any losses on their hedge as you would if you kept a short futures hedge. Above the strike of the call, they would have losses, but they would with their futures hedge anyway. The chart shown in Figure 5 shows the P&L of the options strategy in blue and the expected P&L of the futures position in red. In purple, you see the strategy P&L in 60 days. This shows that until expiration, this options strategy will behave exactly like the futures. The potential benefit comes at expiration if futures prices are higher than here. This is simply a way to attempt to use the options market as a way to gain valuable basis points in relative performance, something all fund managers need to do.

Figure 4 & 5: Eurodollar December 2022 Vol2Vol and projected P&L

Figure 4 Eurodollar December 2022 Vol2Vol and projected P&L
Source: QuikStrike
Figure 5 Eurodollar December 2022 Vol2Vol and projected P&L
Source: QuikStrike

Example: Tactical bullish trade

Figure 6: 10-Year, 2-Year Yield Curve

Figure 7: SOFR June 2022-March 2023 futures spread

Figure 8: SOFR call spread