“I don’t know where I’m going from here, but I promise it won’t be boring.” —David Bowie

It’s a new year, so the market is focused on something completely new, right? Well, not so much. Even though the calendar has flipped to 2023, the market is still debating the pace and direction of FOMC rate moves this year. These rate moves will most likely dictate the direction and volatility of all other asset markets as well.

Perhaps what is new is that traders have a clean P&L slate to work with, or maybe emboldening some to add more risk than they might have a month ago when protecting profits at the year-end when it was more important.

As the FOMC moves are top of mind, the first place I want to look at is the CME FedWatch tool in order to determine what the market is thinking. Viewing the page for the upcoming February FOMC meeting at the start of the month, we can see that the market is assigning more than 75% odds of only a 25 basis point move, with the remaining odds on a more hawkish 50 basis point move.

Looking into last March’s FOMC meeting, we can see 15% odds of no change at all, with the bulk of the odds (66%) thinking there will be an additional 25-basis points (unless of course we do see 50 basis points in February, which then suggests no change in March) and an 18% chance of 50 basis points. Putting this together, we can see that while it is far from unanimous, the market is leaning heavily that the market Fed has only 50 basis points more to hike before it is finished in the near term.

Looking at how these probabilities have changed, we can see that the market has become more dovish in the last one month, pricing in only 50 basis points more in Q1 vs. the possibility of 75 basis points or more only 1 month ago. This is a sea change in perception that has surely been behind a more positive tone to risk of late.

Looking at the Bloomberg WIRP tool, we can see these moves in the Fed Funds translate to a 4.93% expected terminal Fed Funds rate. In fact, in spite of Fed speakers’ comments, we can see there are about 50 basis points of rate CUTS priced into the Fed Funds market in the back half of 2023.

Does this market dovishness make sense? In order to make an assessment, we need to try and understand what the FOMC might be looking at. The Federal Reserve has told us it’s data dependent. A good aggregate way I like to use to assess how the economic data has reported against market perceptions is to look at the Citigroup Economic Surprise Index. It gives a measure not of the absolute level of data, but of how data has been reported relative to expectations. Thus, it’s a mean-reverting series of data since the economists will adjust if it comes in too hot or too cold.

We can see that over the summer last year, from July to November, this series was rising, suggesting it was coming in better (hotter) than expected. This meant the FOMC had more work to do, and we should not have been surprised it was hiking rates this entire time. However, since the end of November, the data series has been moving lower, suggesting it is coming in a bit worse (lower) than expected. Similarly, we should not be surprised that the market is starting to think that the FOMC needs to pause here in the near-term.

I also want to look at the inflation data. The FOMC has a dual mandate of growth (full employment) and inflation (price stability), but given the tightness of the labor market, it has almost uniformly been focused on inflation. The FOMC and Fed Funds have lagged this data for almost a year. You can see inflation starting to move higher in April of 2021, however, the FOMC did not move rates until March of 2022. At that time, the FOMC saw inflation as transitory while many in the market thought the FOMC was behind the curve.

You can now see the inflation rate, as measured by CPI, peaked in June while the FOMC was still looking to hike rates, focused more on not the headline level, but instead breaking inflation into three parts: goods, housing, and ex-housing services. The first two components have clearly slowed, however, the final component has yet to. Traders focused on the headline changes may be the ones anticipating a FOMC that is slowing down if not stopping, while those focused on the last component may find themselves more hawkish than others in the market, and increasingly, in the minority.

Another way to gauge the peak in Fed Funds is to look at the 10-year yield in the U.S. After all, the U.S. 10-year yield can be seen as a sum of all Fed Funds rates for the next 10 years. Thus, as it moves higher, one can interpret this as the market seeing the FOMC needs to do more and as it peaks, that the FOMC may be closed to finished.

Of course, this introduces a lot of yield curve and positioning dynamics which I don’t want to address today, however, we can see that there is a relationship between the market prices (10-year yields) and Fed policy (Fed Funds Rate). The market leads the FOMC and not the other way around.

I have been focusing on the Fed Funds rate in the data analysis, but in my opinion, the best way to express one’s views would be to look to the SOFR market. Comparing the active SOFR futures to the Fed Funds Rate, we can see there is a correlation with the market again leading the FOMC.

In this way, it makes sense to express any view on what the market is pricing into Fed funds and our potential opinion of that pricing via the SOFR futures and options market.

Looking at the active SOFR futures from a technical analysis standpoint, we can see that the market that has declined for a year or more has started to stabilize and, in fact, has started to move marginally higher. The more dynamic measures are moving higher as the RSI diverged from futures at the end of October, with the relative strength not setting new lows even as the future did. In fact, the RSI has shown a series of higher lows. In the middle panel, we can see on the MACD that the moving averages are crossing and pointing higher.

While not suggesting a sharp move higher in the near-term, this chart can be seen to suggest a period of consolidation in the market over the coming months.

In formulating an idea, I also want to look at the CVOL tool to assess the level of volatility that is expected in the market. When we look at all STIR products generally, but SOFR options specifically, we can see the levels of CVOL are at the six month lows across the board.

Volatility is forward-looking, so the market is expecting to be much more calm in the coming months than it has witnessed in previous months.

However, if we look at a longer-term view of the same information, we can see that the current levels are in the middle of the pack as to where they have been. This tells me that if one agrees that we might see more muted price action going forward, there still may be an opportunity on the short side of the volatility market in spite of the CVOLs all being near six month lows.

Next, I look at the term structure of implied volatility to see where there may be some relative mispricing. One can see in this term structure that there is a valley around the March FOMC meeting when the market anticipates the FOMC may stop its rate hikes. In the later half of the year, when the market sees rate cuts, but FOMC speakers are saying the contrary, we see higher levels of uncertainty and higher levels if of implied volatility.

For me, the June expiration looks interesting because it is more elevated than February and March but March is not placed in the back half of the year when the uncertainty may really begin.

If I put this together, I want to find a way to short volatility in the June expiration. However, it is difficult for many traders to carry naked short options positions. Covering every wing can be cost prohibitive to a trader and so one may want to look at which wing makes the trader more nervous. For me, I am still worried about a move lower. I can see the data that suggest the FOMC should pause. However, I can also see that a consensus is building on a pause and if the market were to be disappointed, it would be with a more hawkish FOMC and not with a dovish FOMC.

Interestingly, I can sell the June 95.25 straddle and buy the 95 put and take in 25 points. This means that on any move lower, I will not lose money. The peak of the strategy is at 95.25 where a trader would make the full 25 points. The risk is a move higher in futures above 95.50. This is the breakout scenario on the charts, which most likely is due to a more sudden Fed pivot to being much more dovish, possibly because the data turns quite quickly. Given I am willing to take some risk, and I can determine what might trigger that move, I can look to stop myself out in futures should that scenario happen. Until then, I can hope that a further consolidation occurs, and I can profit from a quiet market in the coming months.

Good luck trading!

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