At last week’s FOMC meeting, Janet came out and – once again, moved the goalposts for FFR hikes. Markets reacted with a snap re-pricing of the dollar and dollar-denominated assets, with the notable exception of US equities. Since then, these moves have reversed and my “reflexivity trade” has played out very nicely as Fed speak has shifted markedly more hawkish than the Fed’s statement and/or presser initially implied.
Today, Yellen will take to the wires and I expect her to – in typical fashion, walk-back from her dovish comments from only a week earlier. We forget how short the market’s memory/attention span is! If Yellen’s sentiment is in line with recent Fed Speak the market should react in favor of my “reflexivity trade” (dollar strength and gold weakness). If however, she sticks to a more dour tone on inflation expectations, the dollar should take it on the chin, in the immediate term. In an effort to hedge against a “Dour Janet,” I’m interested in going long utilities.
The thesis is simple: “Dour Janet” = weak inflation expectation = fewer FFR hikes = weak dollar = lower rates = gold, utilities, treasuries rally
Against a landscape of weak corporate profits and broader uncertainty about the strength of the US economy, I think long utilities fits the “macroscape,” independent of the Chairman’s speech.
To start my analysis I looked at the XLU ETF, itself and the fund’s largest holdings, which include: DUK, NEE, SO, D, AEP and EIX. For these equities, correlations and betas with respect to gold’s front month contract, over a three year horizon were surprising very weak, (largest 0.08 correlation and 0.07 beta).
Since this trade is really a one/two day hedge predicated on recent market moves, I also looked at correlations and betas since the Fed’s last meeting on March 16th. These results are much more robust.
Given that these stocks are among the market’s most “boring,” least volatile, and commoditized businesses, I would have expected them all to have nearly identical 52-week implied volatility percentiles. While this is partly true, markets appear to be pricing EIX much “cheaper” and NEE much more “expensive” than the others.
I ran a simple options pricing analysis using both the long-term (3yr) and recent (since March’s FOMC) correlation and beta data to analyze potential trades for the hedge. Unfortunately, all beta implied moves fell within the current 1-sigma (68%) options implied-probability distribution for APR expiry, so no blatant mispricings were immediately apparent.
My options pricing analysis, using short-term (since March’s FOMC) beta implied targets suggests NEE and D APR calls are the preferred method to hedge a “Dour Janet,” with roughly 150% profit potential.
Using the long-term (3yr) beta implied targets in my options pricing analysis produced different results. The largest difference between the two duration adjustments related to SO’s dominance as a strategy alternative. In the long-term model, SO was the dominant strategy versus all alternatives, whereas in the short-term model SO was dominated by all other strategy alternatives. This is clearly, in-part attributable to SO’s strong price appreciation in 2016 versus its relatively flat price action during 2014 and 2015.
Both models predict DUK as a relatively profitable hedge. However, I believe recent data is particularly more relevant in assessing the strength of correlated asset-class moves during such a short duration hedge as this. In summary, I’ll be opening D 75 APR calls ahead of 12:20pm as a hedge against a “Dour Janet”!