You Can Have the Cake and Eat it Too

CBOT: Treasury Yield Spread 10Y-2YY ( 10Y1! 2YY1! ), Micro Dow ( MYM1! ), Micro S&P ( MES1! )

On Wednesday, the Federal Reserve raises its benchmark Fed Funds rate by 25 basis points to a target range of 4.5%-4.75%. The move marked the eighth consecutive hikes that have began in March 2022. The overnight risk-free rate is now at its highest level since October 2007.

Fed Chairman Jerome Powell sends mixed signals in his post-FOMC meeting news conference but appears more dovish comparing to previous speeches.

The Committee thinks that “on-going increases in the target range will be appropriate”. These words send stocks down minutes after the speech begins at 2:30PM.

However, during the Q&A session, when the Fed Chair confirms, for the first time, that “the disinflationary process has started,” the stock market rebounds strongly and finishes in the positive territory for the day.

Other mixed messages:
• Inflation data shows a welcome reduction in the monthly pace of increases;
• It would be “very premature to declare victory or to think we really got this”;
• It’s “possible” that the funds rate could stay lower than 5%;
• Unlikely the Fed would cut rates this year unless inflation comes down more rapidly.

Actions speak louder than words. In two rate-setting meetings, the Fed has slowed the pace from 75 bps to 25 bps. The path is not likely to reverse, and future rate hikes will come down to just two options, either 0 or 25 bps. In my opinion, the terminal rate will end at 5% or 5.25% after the March and May meeting.

In recent months, the “Risk” button has been pressed on for risky assets:
• The Dow is up 19% since October, and the S&P and the Nasdaq are up 17% and 18% for the same period, respectively;
• Gold futures rallies 21% since November, while Bitcoin jumps 58%;
• Tesla and Ark Innovation ETF gain 47% and 33% year-to-date, respectively.

Historically, it’s rare for the stock market to dip two years or more in a row. For the S&P 500, it only happened four times in the last 100 years. The odds favor stock investors in the Year of Rabbits after a brutal double-digit selloff in 2022.

Fed rate hikes and high inflation are like a brake that decelerated the running economy car. Now that the driver’s foot is off the brake, will the economy improve immediately?

Not so fast. We will endure higher costs for months to come. Take the example of food items, once the price goes up, it usually stays up for the year. Sometimes, suppliers resolve to reducing the size of package for the illusion of keeping the same price, a tactic known as “Shrinkflation”. Wages, rent, phone bill, cable TV, utility, homeowner association fees and sales tax also seldom go down. All these point to a sticky inflation. Without massive government stimulus to press the gas pedal, subdued growth is on the horizon.

However, the stock market is forward looking. Investors already see an "invisible foot" on the accelerator and begin buying in the dip. On balance, I’m bullish about risky assets, but would consider protecting my investments carefully.

The inversed yield curve is a proven and tested signal of a potential recession. The 10Y-2Y Treasury yield spread is at -64 bps after the Fed rate decision. The yield spread turned negative last July and stayed below zero in the last seven months.

Major crises could break out unexpectedly, crashing our party. The year-long Russia-Ukraine conflict could intensify, tensions in the Taiwan Strait could escalate, and the US government might not be able to avoid a national debt default.

A Hedged Position on Stock Index Futures
We could consider using the CME Micro E-mini S&P futures to establish a bullish position on the U.S. stock market. The June contract MESM3 is currently quoted at 4177, which is 58 points above the cash index. To protect my position from any adverse market movement, an out-of-the-money put option could be placed at the 3950-strike. If you are more pessimistic, a lower strike of 3840 may be considered.

The benefit of futures over cash index ETFs lies with the leverage. With a smaller margin deposit upfront, investment return could be amplified if the market moves in your favor. The downside is that the loss will also ramp up quickly if the market moves against you.

Put options protect us from any downfall below the strike price. Unlike futures, the maximum loss from a long options position is the premium you have paid upfront. A combination of long futures and long put options is, in theory, limited downside with unlimited upside.

The risk and return tradeoff are asymmetry in this case. As a result, you can have the cake and eat it too!

Happy trading.

*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 trade set-ups and express my market views. If you have futures in your trading portfolio, check out on CME Group data plans in TradingView that suit your trading needs www.tradingview.com/gopro/

Jim W. Huang, CFA

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