ES: Fed Pivot Breathes Life into Markets
CME: E-Mini S&P 500 Options ( 
ES1!)
Last Wednesday, investors cheered as the Fed kept interest rates unchanged for the second time in a row. On Friday, a soft jobs report backed up market expectations that the rate-hiking campaign is over. For the full week, the Dow was up by 5.07% in its best week since October 2022. The S&P was higher by 5.85% and the Nasdaq gained 6.61%. It was the best week for both indexes since November 2022.
Investors Choose to Ignore What the Fed Says
Stock market behavior shows that the Fed is still the dominant driver. Drilling down further, I find that what moves market is not the actual Fed action, but the expectation of what the Fed would do next. Very often, such market-moving expectations could be in direct contradiction of the Fed Chair’s public statement.
At the post-FOMC press conference, the Fed Chair said that they had not made a decision for the next meeting. He also stated that pausing now would not prevent the Fed from raising rates again. The Fed Chair stressed that they had not discussed if or when to cut rates. The overarching focus now is to bring inflation down to the 2% target rate.
Investors think otherwise. According to CME FedWatch Tool, the probability of keeping rates unchanged on the December 13th FOMC is 95.4% as of November 5th. By the FOMC meeting scheduled on May 1st, 2024, the odds for cutting rates by 25-50 bps are 71%.
(Link: cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html)
Investors acted upon their expectations. Prior to the Fed meeting, Treasury yields were rising sharply. 10Y rose from 4.5% to above 5.0% in 11 days. In the three days following the rate decision, 10Y took a nosedive and now back to 4.6%. This dramatic changes in yields took place while the Fed did nothing.
The stock market rebound could be attributed to the change in expectations too. Lowering rates has the effect of raising the present value of future cash flows, thus increasing a company’s market value, as prescribed by the Discounted Cash Flow valuation method.
The collapse of the US dollar is due to the expectations that it would not generate higher returns without further rate increases, according to interest-rate parity theory.
Let’s look at two more examples:
On July 26th, the Fed raised rates by 25 bps. This was the 11th consecutive rate hike. US stocks rose initially, with the major indexes going up 1-2%. Investors interpreted that this marked the end of Fed tightening. The expectations of Fed Pivot drove market higher, even though the Fed continued to stress the important for fighting inflation.
The September 20th FOMC was the first Fed Pause. On face value, this should have been taken as a huge positive. However, investors believed that the Fed would raise rates one more time by year end. US stocks falls so much that both S&P and Nasdaq lost more than 10% from their high and entered contractionary territory.
Trading with E-Mini S&P Options
What’s the implication from the above observation?
1. Investors may have an easier time forecasting the Fed decision itself than the market reaction after worth. A 95% probability of a Fed Pause could not tell if the stock market would rise or fall after the decision is made.
2. Investor expectations could be adjusted very quickly. Following the Fed decision, the stock market could move up or down by 5% in a week.
We could build an event-driven strategy focusing on the December 13th Fed meeting. If we think that the stock market would make a sizable move after the Fed decision, CME E-Mini S&P Options on Futures could be used to express this view.
The trade would not be built by this single insight only. There are more:
The November jobs report will be released on Friday, December 8th, and the November CPI data will be published on Tuesday, December 12th. These big reports, available to the Fed right before the FOMC, could have a major impact on its rate decision. More importantly, it could alter investor expectations and drive market volatility.
The December 2023 contract (ESE3) will be expired on Friday, December 15th, two days after the FOMC. It is also the “Triple Witching Day”, where US stock index futures, stock index options, and single-stock options contracts all expire on the same trading day.
My writeup from September shows that stock market is highly likely to make a big move on Triple Witching and on the days leading up to it.
With big reports, Fed decision and Triple Witching all within one week, the stock market could enter wild swings as investors digest new data. Time is ripe for options traders.
CME E-Mini S&P 500 Options provide leverage and capital efficiency. Options are based on futures contracts. Contract notional is $50 x S&P 500 Index.
On the morning of November 6th, the December futures contract is quoted 4,384. The out-of-the-money (OTM) call strike 4,580 is the most active call options, with over 50,000 lots traded. If a trader purchases a call and it finishes at 100 points above the strike, she will realize a gain of $5,000 (=50 x 100), minus the upfront premium she paid.
If the market moves against the trade, with the index value below the strike, she will lose money, up to but not beyond the upfront premium.
The OTM put strike traded 1,023 lots. If the trader purchases a put and it finishes 100 points below strike, the trader will also make $5,000, minus the premium.
If the market moves against the trade to finish above the put strike, the trader will lose money, up to but not beyond the upfront premium.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
ES1!)Last Wednesday, investors cheered as the Fed kept interest rates unchanged for the second time in a row. On Friday, a soft jobs report backed up market expectations that the rate-hiking campaign is over. For the full week, the Dow was up by 5.07% in its best week since October 2022. The S&P was higher by 5.85% and the Nasdaq gained 6.61%. It was the best week for both indexes since November 2022.
Investors Choose to Ignore What the Fed Says
Stock market behavior shows that the Fed is still the dominant driver. Drilling down further, I find that what moves market is not the actual Fed action, but the expectation of what the Fed would do next. Very often, such market-moving expectations could be in direct contradiction of the Fed Chair’s public statement.
At the post-FOMC press conference, the Fed Chair said that they had not made a decision for the next meeting. He also stated that pausing now would not prevent the Fed from raising rates again. The Fed Chair stressed that they had not discussed if or when to cut rates. The overarching focus now is to bring inflation down to the 2% target rate.
Investors think otherwise. According to CME FedWatch Tool, the probability of keeping rates unchanged on the December 13th FOMC is 95.4% as of November 5th. By the FOMC meeting scheduled on May 1st, 2024, the odds for cutting rates by 25-50 bps are 71%.
(Link: cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html)
Investors acted upon their expectations. Prior to the Fed meeting, Treasury yields were rising sharply. 10Y rose from 4.5% to above 5.0% in 11 days. In the three days following the rate decision, 10Y took a nosedive and now back to 4.6%. This dramatic changes in yields took place while the Fed did nothing.
The stock market rebound could be attributed to the change in expectations too. Lowering rates has the effect of raising the present value of future cash flows, thus increasing a company’s market value, as prescribed by the Discounted Cash Flow valuation method.
The collapse of the US dollar is due to the expectations that it would not generate higher returns without further rate increases, according to interest-rate parity theory.
Let’s look at two more examples:
On July 26th, the Fed raised rates by 25 bps. This was the 11th consecutive rate hike. US stocks rose initially, with the major indexes going up 1-2%. Investors interpreted that this marked the end of Fed tightening. The expectations of Fed Pivot drove market higher, even though the Fed continued to stress the important for fighting inflation.
The September 20th FOMC was the first Fed Pause. On face value, this should have been taken as a huge positive. However, investors believed that the Fed would raise rates one more time by year end. US stocks falls so much that both S&P and Nasdaq lost more than 10% from their high and entered contractionary territory.
Trading with E-Mini S&P Options
What’s the implication from the above observation?
1. Investors may have an easier time forecasting the Fed decision itself than the market reaction after worth. A 95% probability of a Fed Pause could not tell if the stock market would rise or fall after the decision is made.
2. Investor expectations could be adjusted very quickly. Following the Fed decision, the stock market could move up or down by 5% in a week.
We could build an event-driven strategy focusing on the December 13th Fed meeting. If we think that the stock market would make a sizable move after the Fed decision, CME E-Mini S&P Options on Futures could be used to express this view.
The trade would not be built by this single insight only. There are more:
The November jobs report will be released on Friday, December 8th, and the November CPI data will be published on Tuesday, December 12th. These big reports, available to the Fed right before the FOMC, could have a major impact on its rate decision. More importantly, it could alter investor expectations and drive market volatility.
The December 2023 contract (ESE3) will be expired on Friday, December 15th, two days after the FOMC. It is also the “Triple Witching Day”, where US stock index futures, stock index options, and single-stock options contracts all expire on the same trading day.
My writeup from September shows that stock market is highly likely to make a big move on Triple Witching and on the days leading up to it.
With big reports, Fed decision and Triple Witching all within one week, the stock market could enter wild swings as investors digest new data. Time is ripe for options traders.
CME E-Mini S&P 500 Options provide leverage and capital efficiency. Options are based on futures contracts. Contract notional is $50 x S&P 500 Index.
On the morning of November 6th, the December futures contract is quoted 4,384. The out-of-the-money (OTM) call strike 4,580 is the most active call options, with over 50,000 lots traded. If a trader purchases a call and it finishes at 100 points above the strike, she will realize a gain of $5,000 (=50 x 100), minus the upfront premium she paid.
If the market moves against the trade, with the index value below the strike, she will lose money, up to but not beyond the upfront premium.
The OTM put strike traded 1,023 lots. If the trader purchases a put and it finishes 100 points below strike, the trader will also make $5,000, minus the premium.
If the market moves against the trade to finish above the put strike, the trader will lose money, up to but not beyond the upfront premium.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
Jim W. Huang, CFA
jimwenhuang@gmail.com
jimwenhuang@gmail.com
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