Apr 23, 2022
By Russell Rhoads, head of research
Last week was a fun one with the market reacting to any words that came out of a Fed official’s mouth. Headlines touting the ‘why’ around last week’s market moves did center on Fed speak where I think we got some mixed signals. The week over week result was a big drop in broad based US indices and an increase in volatility. The week over week VIX futures term structure chart demonstrates the increase in volatility expectations.
Possibly more important than the rise in VIX is the change in the shape of the curve. The textbook definitions of the term structure give us a choice between contango and backwardation. However, I think there is a third state of the curve that I call ‘flat’ (I am a numbers guy, not a marketer so I am sure there is a better term than ‘flat’). On the 4/22/2022 curve, all prices from spot VIX to November fall within a 0.65 range. I have always associated a flat VIX term structure with excess uncertainty in the markets. Mixed signals from the Fed will do that to market expectations.
Over in Europe, the Euro Stoxx 50 dropped just over 8 points or 0.02%. Despite the small move in the underlying market, VSTOXX rose 1.59 with the curve finishing the week nearly as flat as the VIX curve.
The Fed created the uncertainty in the US, while heightened volatility expectations in Europe are a function of this weekend’s election in France. Some traders expect the typical volatility crush in VSTOXX that accompanies “known unknown” like this weekend’s final round of the French election. One trade, on Friday, consists of a butterfly using May put options looking for a measured move in VSTOXX to around 20.00 between now and May expiration.
With VSTOXX at 27.65, the trade purchased 2,000 of the VSTOXX May 23 Puts for 0.675 and 2,000 VSTOXX May 17 Puts for 0.025. The spread was completed with a purchase of 4,000 VSTOXX May 20 Puts for 0.125 each resulting in a net cost of 0.50 and a payoff at expiration shown below.
Measure moves with options are popular with individual stock option traders, especially around earnings announcements. I have never been a fan of those types of trades, but do think they make sense in the volatility space.
Circling back to the next Fed rate decision. Many market observers made it sound like there was a dramatic shift regarding the Fed’s stance on rate hikes. However, despite reported uncertainty the derivative markets maintained a high level of conviction behind a 50 bp hike next month with the figure trending to almost 100% by the end of the week.
The small blip lower, from just over 90% to just under 90% at the start of last week is not exactly a reaction that matches up with the recent commentary. Finishing the week at 100% is an indication that any Fed uncertainty is farther into the future. A 50 bp hike in May places the target rate at 0.75% to 1.00%.
The big shift in anticipated Fed action focused on the next meeting. This one is on June 15 and as of Friday, the market started pointing to a 75 bp hike, placing the target rate at 1.50% to 1.75%. The chart below shows how quickly the market shifted from very little chance of a 75 bp hike in June to over a 90% chance of this outcome.
Looking farther out into the future, current pricing points to the target rate falling between 2.75% and 3.00% at the final meeting of the year (December 14). Although much higher than the Fed Funds target rate for the past few years, this is closer to a historically average level than an elevated one.