Risk strikes when least expected. Optimism peaks before a downturn strikes. Chart below shows remarkable spike in articles mentioning soft-landing before recession hits. Human brain is engineered to think linearly.
Anything non-linear tricks the mind. Recession is non-linear which muddles up investor estimates of recession, its timing and impact.
Count of Soft-landing Articles & US Recession (Source: Bloomberg)
The US Federal Reserve in its fight against inflation has lifted rates by an unprecedented 525 basis points since the start of 2022.
Yet the American economy, US corporations, and the US consumer are remarkably resilient. Non-Farm Payrolls last week came strong. When the Fed is tightening its levers to slow the economy, nothing seems to stop its rise. What explains this anomaly?
Three words. Monetary Policy Transmission.
Monetary policy transmission takes time, lulling many to believe that consumers and corporates are resilient. When in fact, they are yet to face the consequence of constrained credit markets which will manifest itself in myriad ways from reduced availability of financing, high cost of funding, and rising bankruptcies, just to name a few.
This paper is set in two parts. First part describes monetary policy transmission. Part two dives into storms forming in the horizon. The paper concludes with a hypothetical trade set-up using CME Micro S&P 500 Options to defend portfolios from deepening polycrisis.
Despite the risk narratives, a soft landing may still be possible. However, the combined impact of Fed’s hawkish stance, rising geopolitical tensions, continuing auto workers strike, tightening of financial conditions, and elevated oil prices & yields renders the likelihood of a soft landing, super slim.
Narratives around the soft-landing aside, CTAs have dumped nearly USD 40 billion worth of S&P 500 futures positions marking the fastest unwind on record over the last two weeks as reported by Goldman Sachs.
PART 1: MONETARY POLICY TRANSMISSION
Monetary policy operates with long and unpredictable lags. Monetary Policy Transmission is the process through which a Central Bank’s decisions impact the economy and the price levels. The flow chart below schematically describes the downstream impact of quantitative tightening.
Monetary Policy Transmission Takes Time (Source: ECB)
Changes made to official interest rates affect markets in diverse ways and at distinct stages. Central bank's interest rate decisions impact the markets in the following seven ways:
1. Banks and Money Markets: Rate changes directly affect money-market rates and, indirectly, lending and deposit rates.
2. Expectations: Expectations of future rate changes influence medium and long-term interest rates. Monetary policy guides expectations of future inflation.
3. Asset Prices: Financing conditions and market expectations triggered by monetary policy cause adjustments in asset prices and the FX rates.
4. Savings & investment decisions: Rate changes affect saving and investment decisions of households and firms.
5. Credit Supply: Higher rates increase the risk of borrower default. Banks scale back on lending to households and firms. This may also reduce consumption and investment.
6. Aggregate demand & prices: Changes in consumption and investment will change the level of domestic demand for goods and services relative to domestic supply.
7. Supply of bank loans: Changes in policy rates affect banks’ marginal cost for obtaining external finance differently, depending on the level of a bank’s own resources/capital.
The mechanism is characterized by long, variable, and indefinite time lags. As a result, it is difficult to predict the precise timing of monetary policy actions on economy and inflation.
For some sectors, monetary policy transmission can take as long as 18 to 24 months. In other words, the full force of the Fed’s 525 basis points spike since 2022 will not be felt until early 2024. Added to that, the Fed may not be done hiking yet.
Probabilities of Rate Anticipation in Prospective Fed Meetings (Source: CME FedWatch Tool)
PART 2: STORMS ARE FORMING
Not one but three major storms are brewing in parallel, namely (1) Worsening Geo-politics, (2) US Sovereign Risk Fears, and (3) Tightening Financial Conditions. One or more of them could unleash havoc, sending financial markets into a tailspin.
1. WORSENING GEO-POLITICS
Adding to the geopolitical conflict between Russia and Ukraine, Hamas attack on Israel over the weekend has elevated geo-political tensions. If counter strikes escalate to a wider region impacting Strait of Hormuz, then oil prices could spiral up sharply, sending shocks across financial markets.
Oil prices lost steam last week. That doesn’t guarantee lower prices. Eerily, this month marks 50-year anniversary of oil emergency in 1973 which led to oil prices spiking 3x back then.
The US Strategic Petroleum Reserves are at a 40-year low. The reserves are at 17-days of consumption compared to an average of 34-days consumption observed over the last thirty years.
2. US SOVEREIGN RISK FEARS: The US government is facing multiple challenges of its own. The government narrowly avoided a shutdown and has kicked the problem can down the road only by six weeks. Long before investors take relief, the shutdown fear will resurface again.
Add to that is the rising US debt levels. With a debt burden of USD 33 trillion, the government debt is forecasted to reach USD 52 trillion by 2033.
With rates remaining elevated, a substantial chunk of US Government debt will be directed towards interest payments. Is there a risk of US debt default?
To compensate for that risk, bond yields are climbing. The 10-Year treasury yields rose to 16-year high of 4.6%. With jobs market remaining solid, the data-driven Fed might have to keep the rates higher for longer.
The futures market implies a probability of 42% for a rate hike during the Fed’s December meeting. Any further hikes can tip the recovering housing market back into crisis due to exorbitant mortgage rates. High yields also cost it dearly for firms to borrow.
3. TIGHTENING FINANCIAL CONDITIONS: Dwindling liquid assets, resumption of student loan repayments, stringent lending practices atop heavy debt burden on US Corporates are collectively weighing down on investor sentiments.
Student Loan Repayments: After 3.5 years of loan servicing holidays, millions of students will resume student loan repayments. Bloomberg estimates that these repayments can shave 0.2% to 0.3% off US GDP.
Depleted Savings: Strength of the US Consumers will be put to stress tests. Extra savings from pandemic stimulus checks have been depleted to below pre-pandemic levels for low-income categories. Consumer strength could turn into weakness in the coming weeks.
Inflation Adjusted Liquid Asset Holdings by Income Group (Source: US Fed and Bloomberg Calculations)
Stringent Lending Standards: The Fed’s Senior Loan Officer Opinion Survey (SLOOS) on Bank Lending Practices points to 50% of the banks imposing stringent criteria for commercial & industrial loans. Lending conditions are at levels last seen during 2008 global financial crisis. Impact of this will be felt in Q4 when business will be stifled from access to funds.
Tightening Standards of Commercial & Industrial Loans (Source: July 2023 SLOOS Survey)
Corporate Debt Burden: Years of extremely low cost of funding have tempted US corporates into a debt binge. With rates rising, the debt burden is getting heavier on corporate balance sheets, cash flows, and profitability as reported by Bloomberg. Leverage ratios are rising. Interest coverage ratios are falling. Average Free Cash Flow to Debt ratios are plunging.
Debt burden amid rising rate environment is hurting US Blue Chips (Source: Bloomberg Intelligence)
HYPOTHETICAL TRADE SETUP
Against the backdrop of these risks, this paper posits a hypothetical back spread with puts to gain from sharp index moves. Unlike a long straddle, this option strategy delivers (a) outsized gains when markets plunge, and (b) limited downside risk if market remains flat or rises despite the risks.
This strategy involves selling one unit of at-the-money puts to finance purchase of two units of out-of-the-money puts. This strategy can be executed either for net positive premium or net negative premium depending on the choice of strikes.
Specifically, the hypothetical trade illustration is built around CME Micro Monthly S&P 500 Options expiring on 29th December 2023 (EXZ3). The strategy involves (a) selling 1 lot of EXZ3 at a strike of 4400 collecting a premium of USD 655 (131.16 index points x 1 lot x USD 5/index point), and (b) buying 2 lots of EXZ3 at a strike of 4300 paying a premium of USD 950 (95.041 index points x 2 lots x USD 5/index point).
The hypothetical trade involves a net debit of USD 295 (58.922 index points * USD 5/index point). This trade breaks even when S&P 500 (a) falls below 4141, or (b) rises above 4400.
Pay-off from Back Spread with Puts Trade Strategy (Source: CME QuikStrike)
Summary pay-off from this trading strategy is illustrated in the table below.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Anything non-linear tricks the mind. Recession is non-linear which muddles up investor estimates of recession, its timing and impact.
The US Federal Reserve in its fight against inflation has lifted rates by an unprecedented 525 basis points since the start of 2022.
Yet the American economy, US corporations, and the US consumer are remarkably resilient. Non-Farm Payrolls last week came strong. When the Fed is tightening its levers to slow the economy, nothing seems to stop its rise. What explains this anomaly?
Three words. Monetary Policy Transmission.
Monetary policy transmission takes time, lulling many to believe that consumers and corporates are resilient. When in fact, they are yet to face the consequence of constrained credit markets which will manifest itself in myriad ways from reduced availability of financing, high cost of funding, and rising bankruptcies, just to name a few.
This paper is set in two parts. First part describes monetary policy transmission. Part two dives into storms forming in the horizon. The paper concludes with a hypothetical trade set-up using CME Micro S&P 500 Options to defend portfolios from deepening polycrisis.
Despite the risk narratives, a soft landing may still be possible. However, the combined impact of Fed’s hawkish stance, rising geopolitical tensions, continuing auto workers strike, tightening of financial conditions, and elevated oil prices & yields renders the likelihood of a soft landing, super slim.
Narratives around the soft-landing aside, CTAs have dumped nearly USD 40 billion worth of S&P 500 futures positions marking the fastest unwind on record over the last two weeks as reported by Goldman Sachs.
PART 1: MONETARY POLICY TRANSMISSION
Monetary policy operates with long and unpredictable lags. Monetary Policy Transmission is the process through which a Central Bank’s decisions impact the economy and the price levels. The flow chart below schematically describes the downstream impact of quantitative tightening.
Changes made to official interest rates affect markets in diverse ways and at distinct stages. Central bank's interest rate decisions impact the markets in the following seven ways:
1. Banks and Money Markets: Rate changes directly affect money-market rates and, indirectly, lending and deposit rates.
2. Expectations: Expectations of future rate changes influence medium and long-term interest rates. Monetary policy guides expectations of future inflation.
3. Asset Prices: Financing conditions and market expectations triggered by monetary policy cause adjustments in asset prices and the FX rates.
4. Savings & investment decisions: Rate changes affect saving and investment decisions of households and firms.
5. Credit Supply: Higher rates increase the risk of borrower default. Banks scale back on lending to households and firms. This may also reduce consumption and investment.
6. Aggregate demand & prices: Changes in consumption and investment will change the level of domestic demand for goods and services relative to domestic supply.
7. Supply of bank loans: Changes in policy rates affect banks’ marginal cost for obtaining external finance differently, depending on the level of a bank’s own resources/capital.
The mechanism is characterized by long, variable, and indefinite time lags. As a result, it is difficult to predict the precise timing of monetary policy actions on economy and inflation.
For some sectors, monetary policy transmission can take as long as 18 to 24 months. In other words, the full force of the Fed’s 525 basis points spike since 2022 will not be felt until early 2024. Added to that, the Fed may not be done hiking yet.
PART 2: STORMS ARE FORMING
Not one but three major storms are brewing in parallel, namely (1) Worsening Geo-politics, (2) US Sovereign Risk Fears, and (3) Tightening Financial Conditions. One or more of them could unleash havoc, sending financial markets into a tailspin.
1. WORSENING GEO-POLITICS
Adding to the geopolitical conflict between Russia and Ukraine, Hamas attack on Israel over the weekend has elevated geo-political tensions. If counter strikes escalate to a wider region impacting Strait of Hormuz, then oil prices could spiral up sharply, sending shocks across financial markets.
Oil prices lost steam last week. That doesn’t guarantee lower prices. Eerily, this month marks 50-year anniversary of oil emergency in 1973 which led to oil prices spiking 3x back then.
The US Strategic Petroleum Reserves are at a 40-year low. The reserves are at 17-days of consumption compared to an average of 34-days consumption observed over the last thirty years.
2. US SOVEREIGN RISK FEARS: The US government is facing multiple challenges of its own. The government narrowly avoided a shutdown and has kicked the problem can down the road only by six weeks. Long before investors take relief, the shutdown fear will resurface again.
Add to that is the rising US debt levels. With a debt burden of USD 33 trillion, the government debt is forecasted to reach USD 52 trillion by 2033.
With rates remaining elevated, a substantial chunk of US Government debt will be directed towards interest payments. Is there a risk of US debt default?
To compensate for that risk, bond yields are climbing. The 10-Year treasury yields rose to 16-year high of 4.6%. With jobs market remaining solid, the data-driven Fed might have to keep the rates higher for longer.
The futures market implies a probability of 42% for a rate hike during the Fed’s December meeting. Any further hikes can tip the recovering housing market back into crisis due to exorbitant mortgage rates. High yields also cost it dearly for firms to borrow.
3. TIGHTENING FINANCIAL CONDITIONS: Dwindling liquid assets, resumption of student loan repayments, stringent lending practices atop heavy debt burden on US Corporates are collectively weighing down on investor sentiments.
Student Loan Repayments: After 3.5 years of loan servicing holidays, millions of students will resume student loan repayments. Bloomberg estimates that these repayments can shave 0.2% to 0.3% off US GDP.
Depleted Savings: Strength of the US Consumers will be put to stress tests. Extra savings from pandemic stimulus checks have been depleted to below pre-pandemic levels for low-income categories. Consumer strength could turn into weakness in the coming weeks.
Stringent Lending Standards: The Fed’s Senior Loan Officer Opinion Survey (SLOOS) on Bank Lending Practices points to 50% of the banks imposing stringent criteria for commercial & industrial loans. Lending conditions are at levels last seen during 2008 global financial crisis. Impact of this will be felt in Q4 when business will be stifled from access to funds.
Corporate Debt Burden: Years of extremely low cost of funding have tempted US corporates into a debt binge. With rates rising, the debt burden is getting heavier on corporate balance sheets, cash flows, and profitability as reported by Bloomberg. Leverage ratios are rising. Interest coverage ratios are falling. Average Free Cash Flow to Debt ratios are plunging.
HYPOTHETICAL TRADE SETUP
Against the backdrop of these risks, this paper posits a hypothetical back spread with puts to gain from sharp index moves. Unlike a long straddle, this option strategy delivers (a) outsized gains when markets plunge, and (b) limited downside risk if market remains flat or rises despite the risks.
This strategy involves selling one unit of at-the-money puts to finance purchase of two units of out-of-the-money puts. This strategy can be executed either for net positive premium or net negative premium depending on the choice of strikes.
Specifically, the hypothetical trade illustration is built around CME Micro Monthly S&P 500 Options expiring on 29th December 2023 (EXZ3). The strategy involves (a) selling 1 lot of EXZ3 at a strike of 4400 collecting a premium of USD 655 (131.16 index points x 1 lot x USD 5/index point), and (b) buying 2 lots of EXZ3 at a strike of 4300 paying a premium of USD 950 (95.041 index points x 2 lots x USD 5/index point).
The hypothetical trade involves a net debit of USD 295 (58.922 index points * USD 5/index point). This trade breaks even when S&P 500 (a) falls below 4141, or (b) rises above 4400.
Summary pay-off from this trading strategy is illustrated in the table below.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
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