In case you missed it, the Fed speak over the last week, and the Minutes of the the FOMC’s April meeting put to be bed the debate whether or not their June FOMC get together is a “live” meeting. In hindsight, market participants were dramatically under-pricing the potential for their second interest rate hike in nearly 10 years, and the first since December, as Fed Fund futures went from pricing a 4% chance late last week, to a 32% probability of a June raise:
Yesterday, for BloombergView, Mohamed A. El-Erian discussed some of his takeaways from the April Minutes. It’s El-Erian’s view that Fed officials were worried that market participants under-priced the potential for a June increase and they wanted to get that sorted a bit with the April gathering. Fed officials sought to correct this misconception, including by spelling out developments that could warrant an increase as early as June. (emphasis mine):
This notable signal reflected Fed expectations that the all-important labor market would continue to strengthen, improving prospects for economic activity and inflation over the medium term.
Officials also welcomed the recent decline in risks posed by global economic and financial conditions. And they noted that the domestic outlook was further enhanced by significant improvements in U.S. and international financial conditions.
The first point about labor market and inflation is likely to remain confusing as the April non-farm payrolls report was well below expectations, despite the unemployment rate hitting the Fed’s previous target of 5%. On the flip-side, just this week we saw measures of inflation tick up at their fastest rate in months and to its highest levels in 5 years, but still below their 2% target. So your guess is as good as mine what happens at the June meeting if May Non-Farm Payrolls disappoint.
And the second bit I find most interesting. The easing of global economic conditions. Yep, things were a bit haywire in Jan/Feb, the dollar was at 52 week highs, gold was ripping, stocks got creamed, Treasury Yields made new lows, commodities careened and fear of defaults had high yield credit on the tips of most market participant’s tongues. With the decline in the dollar in March/April, the subsequent rally in commodities, stocks and yields have clearly eased economic conditions. But if the Fed is going to raise, will we see the dollar rip again and commodities give back a good bit of their gains from the lows? And will this raise the chance of commodity related credit defaults and/or bankruptcies?
Who knows? But one trader looked to be buying some protection or making an outright bearish bet for a re-test of the prior lows in the HYG (the iShares High Yield etf) yesterday. When the etf was $82.70, a trader bought to open 22,500 of the Dec 75 puts for $1.33, or about $3 million in premium. These puts break-even at $73.67, down 11% from the trading levels, and below the 52 week lows made in February.
When looking at the one year chart, the 200 day moving average is about to cross below the rising 50 day moving average, which some technicians refer to as a death cross.
If you were in the camp that a move of the US dollar back towards the prior highs could set off some alarm bells in global risk assets, long volatility strategies in the HYG might make sense as it is some of the cheapest vol on the board, with 30 day at the money implied vol a tad below 10%, with the Dec out of the money calls just 14%:
We have taken a similar view on the site (read here from early March), but I’d much prefer nearer to money participation, and possibly look to own the 80 strike and sell the 75 strike (the prior low) and make a vertical put spread.
I maintain my view that the Fed will not raise in June, not a week before the Brexit vote in the U.K and given the likelihood that U.S. economic data stays spotty and China’s weak, they will be offered another excuse in the coming weeks not to raise. It’s also my view that 2016 is setting up very similarly to 2015, and the if the Fed remains accomadative that will because economic conditions continue to deteriorate, which will be bad for risk assets, as they were in August/September 2015 & January/February 2016. Or if they get to hawkish and the U.S. dollar rallies too far too fast will also be bad for risk assets. The worst bet on the board may be that the Fed threads the needle and nails normalization.
Regular readers know i’d rather be long the S&P 500 (SPX) to any other equity index at the world at the moment, but the technical set up, and what in my mind has been a clear narrowing of leadership poses risk to the SPX re-testing the 2016 lows in my mind at some point in the coming months:
This chart bothers me, the rejection at the 5 year uptrend, and the February low, which was the first low that was below a prior low since the start of the rally in March 2009.