Will she or wont she? 81.4%, down just a touch from yesterday’s 83.3% say, ‘she will.’
When conviction is super high, trades get crowded and markets get one-sided. Um, remember the 5+ sigma move in EUR/USD post Draghi’s disappointment, last week? One-sided markets offer great opportunities for asymmetrical risk.
Before we highlight potential asymmetrical risk trades, here’s what I expect to happen on Wednesday.
- She “hikes” 25bps
- Sentiment will be firmly and prudently dovish, but not excessively dovish, as I believe markets expect.
- She’ll emphasize
- International markets have stabilized
- Transitory nature of low oil prices
- Data dependency of trajectory
- No preconceived schedule of hikes exists
- Clearly articulates no move at next meeting
- June is next “in-play” meeting
With the exception of my belief that she will be less dovish than the market expects, pretty much everything else is par for market expectations. That said, I do believe that the dot plot could rattle some algos and first movers. Um, remember Kocherlakota’s negative dot in September? I wouldn’t be surprised to see his 2017 dot fall below 1.00% and potentially his 2018 dot at or below 2.75%. Similarly, I think it’s equally likely to see some of the hawks’ dots move higher.
Given these expectations, where does asymmetrical risk exist?
Going into tomorrow’s FOMC decision, I see standalone asymmetrical risk in each of these assets if Janet goes with the 20% and doesn’t move.
Starting with the USD. Yes, longs got burned a la Draghi, but the market still sees global monetary policy divergence as a stedfast theme, albeit to a lesser degree. Dollar strength doesn’t lie with a single rate rise. Instead it relies on the expectation of subsequent rises following the commencement of lift-off. A surprise fold, would push lift-off another 6 months down the road, too far into the future for dollar-longs to finance the trade as vigorously.
Short USD is the first-level trade. Where can we find more beta? Maybe EURUSD? Equity markets expect a hike, and par for that expectation will be bullish for stocks = Short EUR and buy US stocks. Folding will firstly be fundamentally bullish for the EUR/USD cross and secondly bearish for equities, which will further strengthen EUR/USD due to carry trade unwinds. USDCHF? With the world’s lowest interest rates (-0.75%), it makes sense that if the Fed doesn’t move, you’ll see outsized strength in CHF. Combining the two, go long EUR/CHF.
On to Oil. Regardless of where you think oil should be trading – I can make a strong case for lower, it’s simply very oversold. We’ve seen oil characteristically, over-correct when RSI falls to ~20, which it did last Friday. Moreover, historically, we’ve seen buying into WTI futures options expirations 8 of the last 11 times – December crude options expire tomorrow.
The last 5 over-corrections to the upside have averaged + 15.4%. From Friday’s lows, that takes us to $40.
Last week, Bloomberg reported that open interest in the December $35 puts reached an all-time high. With all those options turning ITM on Monday, you can be assured, the $35 level will be hedged/frontrun away from, higher. Coupled w Fed that doesn’t move, and a weaker USD, Oil has plenty of room to way over-correct above $40.
Looking for higher beta on the oil trade? What about commodity currencies, CAD and AUD. I’m more familiar with trading CAD. It tracks oil prices very well and coupled with a weaker dollar, it could be a nice short.
Rounding it out with high yield. I have limited experience trading high-yield – I tried going long after the June ECB meeting, but nothing materialized. That said, the current hysteria that the world is falling apart courtesy of junk screams of an over-reaction. If the Fed doesn’t move, we’re expecting 6 more months of inaction. That’s plenty of time for rates to reverse lower and markets to be caught off-sides, again.
With so much high yield tied to oil prices, a strengthening in oil prices will sure up high yield NAVs and could lead to a short squeeze higher.
What I’m trading:
- Been long /NQ calls
- Adding long EUR/CHF, looking for 1.1140, stop 1.0784
- Adding long /CL $40 Jan calls