The FOMC meets on Dec 13th and 14th with an announcement of their first rate hike in a year expected on the afternoon of the 14th. Odds of a .25 rate hike at the meeting now stand at about 95%:
That’s as much of a sure thing as you’re going to see. What is still uncertain is what the path in 2017 looks like for the FOMC. Yellen is on record that the Fed is basically at their employment target and that inflation is now a concern, specifically mentioning the fiscal stimulus plan that she had been begging for for the past few years to take some of the pressure off the Fed. From The USA Today:
“The economy is operating relatively close to full employment at this point,” Yellen told the Joint Economic Committee. As a result, massive government outlays would drive up inflation as employers bid up wages to attract a limited pool of workers.
By contrast, she said, the economy needed a jolt to anemic demand after the 2008 financial crisis.
Said Yellen: “The long-run deficit probably needs to be kept in mind.” The national debt, she noted, is about 77% of gross domestic product, adding, “There’s not a lot of fiscal space should a shock to the economy occur.”
Yellen said she was not passing judgment on Trump’s plan to spend $550 billion to upgrade the nation’s crumbling infrastructure, boost defense spending and cut taxes sharply. That, she said, is Congress’ role. In the past, Yellen has urged Congress to pass fiscal stimulus to take the burden of goosing a sluggish economy off the Fed alone.
Her remarks Thursday (Nov 17th), however, reflect a new landscape now that the unemployment rate is at a near-normal 4.9%, down from 10% in 2009.
Inflation expectations, which were already rising, have shot up since the election as a Republican super-majority in Congress and a somewhat populist White House means we can expect lower taxes and deficit spending for things like infrastructure and the military. This comes at a time of a fairly strong economy and, as Yellen mentioned, pretty much full employment.
So the big question for the December meeting is what kind of path the FOMC lays out, and probably more importantly is what inflation and interest rate expectations do, as that could be something that spooks markets.
We’ve laid out a trade to be long vol when the VIX is low numerous times in the past, and we often time it to FOMC meetings for expiration. The majority of the time this trade structure finishes worthless, so we like to do it for zero cost (or close to that). The times when it does work on VIX spikes it acts as a great look either as a straight up bet or in it’s own way as a hedge sensitive holdings in a portfolio. We get a lot of questions about being long vol through the etn’s like VIXY and VXX and our answer to those questions is “buyer beware”. For more on those products, read here, here, and here.
I’m going to lay out the trade idea targeting the December FOMC meeting and in the rationale I’ll explain how the risk/reward works on this trade
*VIX ($14) Sell the Dec 13.5 put at .55 to buy the 17/22 call spread for even money
- Sell 1 Dec 13.5 put at .55
- Buy 1 Dec 17 call for .95
- Sell 1 Dec 22 call at .40
Rationale – This trade can be executed for even money. That means if the VIX settles between 13.50 and 17 on December expiration there is no gain or loss. If the VIX spikes between now and then it can be worth up to $5 between 17 and 22, with the max gain above 22. The risk to the downside is if the VIX settles below 13.50. That’s impossible to quantify exactly how much risk there is, but the VIX rarely trades below 10. The most likely scenario is that this is risking about 1.50 if the VIX settled at 12. It has not settled (monthly) below 12 since last Summer, and even this past August, when vol felt historically low its lowest (monthly) settlement was 12.20.
So 12 is about right for the risk (meaning 1.50 at risk). And with the Dec VIX futures currently around 15, you have some time to close this if that 13.5 strike starts to look like it’s at risk (by watching the Dec VIX Futures)