Thursday is Fed Day. These are generally volatile days for the markets. Volatility can make options traders money.
Fed Days are when we get announcements from the Federal Open Market Committee (FOMC).
This is the group that determines monetary policy. After FOMC meetings, the Fed issues a statement that talks about risks to the economy and a broad look at policy.
The FOMC meets eight times a year at regularly scheduled meetings. (The Chairman can also convene emergency meetings which are rare and almost always occur in the midst of a crisis).
Statements from the Fed tend to be bland and full of “Fed Speak.” Think doublespeak from Nineteen Eighty-Four but less evil (probably).
After the last meeting, the FOMC statement said:
“The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.”
That was a long way of saying: 1) There are no changes to policy and 2) no changes are expected for at least the next year.
Because there was no change, the response from stock traders was relatively muted. Stocks fell about 0.5% after the announcement. The next day, there was a 1% rally.
Bond traders saw more extreme moves. In three days, the interest rate on ten-year Treasury notes went from 1.55% to 1.69%. That’s a big swing, twice the average volatility seen in that market.
As interest rates rise, bond prices fall. A small move like that is worth about 1% of the account value to traders in the bond market. Bond traders like to make 5% a year. So a 1% move in three days is scary.
Because many banks held billions of dollars’ worth of Treasury notes, they suffered large losses. Fed Chairman Jerome Powell rushed to reassure traders that rates really would stay low (we promise), and Treasuries recovered their losses within a week. The S&P 500 also responded to Powell’s damage control efforts and gained 1.5% in that week.
When Powell Speaks, Run
There’s a larger point here.
Gains are rare after Powell speaks.
In the past, Fed Days had a strong bullish bias. Buying call options on SPDR S&P 500 ETF (NYSE: SPY) was usually profitable.
Since Powell became Chairman, Fed Days have recorded consistent losses.
And Powell faces an especially challenging week.
Before the Fed begins its meeting, data on the Producer Price Index (PPI) will be released. PPI measures price changes from the seller’s perspective. This index offers details on how much more manufacturers and service providers are paying for goods. Jumps in consumer inflation often follow gains in PPI.
Here’s why this matters: If PPI shows higher than expected inflation, the Fed will be under pressure to change its policies. A change in policy could lead to a stock market selloff.
(Remember, stocks like interest rates to stay low. If inflation goes too high, the Fed is pressured to raise rates. Higher rates spook markets that have been doped up on low interest rates for 12 years now).
That said, the Fed will be reluctant to change policy even if PPI is relatively high. FOMC members will be discussing how well the economic recovery is doing and recent data shows the recovery has stalled.
This is a “damned if they do, damned if they don’t” kind of situation. If inflation is high the Fed has to raise rates. If it looks like the recovery is stalling markets won’t like that either.
A Look Ahead
A quick way to stay ahead of the curve, track the economic data and observe trends is to look at the CNN Back-to-Normal Index.
This index includes 44 different economic indicators that are updated at least once a week.
When the index reached 100%, the economy will be back to its pre-pandemic level in March 2020. Last week, the index dipped 3%.
The Fed will dig into the underlying data to determine if the recovery is faltering. We’ll learn their proceedings on Thursday.
If the Fed decides the recovery is in danger, they aren’t likely to change policy. Traders might react to no change in policy by selling.
The Fed is in a tough position, and that forces traders into an equally tough position. The best trade for the week could be put options on SPY.
I give more exact instructions in One Trade. We don’t trade SPY, we trade DIA. I am looking to add put options this week. Since options suffer from time decay, timing matters. I will alert One Trade readers when it’s the right moment to strike. The full strategy is laid out right here.
Michael J. Carr CMT CFTe
Editor, One Trade
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