Summary — Dec 19, 2018
In the last 24h, the intensity of the US Dollar sell-off gathered further steam. This dynamic indicates that the market is not placing too high its hopes on the Fed. In fact, the behavior in the US Dollar leading up to today’s FOMC event communicates the market is betting for an uber-dovish rate hike. In other words, the FOMC may still raise its interest rate one more time, although it will probably set the bar much higher to keep the tightening campaign going.
If they opt for the dovish hike, it won’t necessarily look like a Central Bank compromised by the recent tweets of Trump, but rather, acting in a way that helps to ease the further tightening of financial conditions, a dynamic that has only worsened via higher funding costs/lower liquidity in the system. The flattening of the US yield curve also communicates the Central Bank is getting ahead of itself. These developments disincentivize the Fed to keep its aggressive rate hike rhetoric, so they’d be less compelled and keep the powder dry, even if they will continue to highlight, especially via such a pragmatist as Fed’ Powell is, that the Central Bank will remain data-dependent.
One of the most pressing issues to address in today’s FOMC meeting includes the update of the dot plot rate forecasts, as well as potential upcoming revisions to the Fed’s balance sheet normalization process.
The only way to explain the changes in option premiums heading into the event is by accepting as true that the market’s view — as a hint — is that expectations for rate hikes heading into 2019 may be nullified as the eurodollar futures market or the US yield curve indicate. Similarly, we might see a Fed shifting the narrative towards an adjustment in its balance sheet normalization process too. Only under these dovish circumstances or similar in USD downside impact I can justify the change in options pricing.
Let’s now get into the details. What I’ve learned from today’s cross-asset analysis, judging by the variations in the pricing of options, is that the consensual view via US treasuries and equities substantiates the notion that the Fed may be working to engineer some type of circuit breaker in the soulless stock market. Even if the pricing to own puts in the E-mini S&P 500 is still much more expensive, the major reduction in premium cannot be ignored and tells us that the market is less bearish in equities heading into the event.
Just as it cannot be ignored the higher prices to own calls in US treasuries, jumping by over 100% from its previous 25-delta RRs. Throw into the mix the decrease of over 0.5bp in 25-delta risk reversals in the USD/JPY, and it looks like the US Dollar is poised to suffer further downside pressures. However, it may not be a broad-based move, as commodity currencies still remain largely unfavoured, not just in its spot technicals, but via the pricing of options.
That’s what options traders are telling us. They certainly have taken note, as bond traders did via the flattening of the US curve, that trade tensions, the fading of the fiscal ‘sugar rush’, the US twin deficits, weakness in the housing market, the slow down in investment growth, the late business cycle, Powell’s shift in narrative from a long way from neutral (October 3rd) to rates being “just below” estimates of neutral policy (November 28th), when compounded, place the risks of a more relaxed Fed into 2019, outweighing the pros.
In today’s report, I’ve also noted additional downside protection bought — via OTM puts — in the EUR/USD this week. I’ve recently been endorsing and playing EURs from the long side, as I explain in the video below.
A market that I find very interesting to endorse in buy-side action if the view by options traders materializes is gold. Vol is going to pick up substantially, and while some pairs such as the EUR/USD, AUD/USD, judging by its implied vols, may still be contained in wider yet familiar ranges, gold appears to be an exception, along with the EUR/JPY, amid a low gamma-scalping context.
All in all, brace yourself for a wild ride, in what’s set to be one of the major events of the entire year. It will set into motion the stage to approach 2019 with from a point of greater clarity to diversify one’s portfolio.
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