- Market volatility may spike further as Federal Reserve officials grow more hawkish, BTIG cautions.
- Inflation and “memetic” surges in stocks, commodities, and crypto have taken center stage.
- Investors can capitalize on the forthcoming volatility with a straddled S&P 500 options trade.
Surprisingly hawkish sentiment from the Federal Reserve last week upset markets and jolted volatility higher, leaving investors to grapple with how large of a threat rising inflation really poses.
The US central bank’s apparent willingness to raise interest rates twice in 2023 in response to signs of hotter inflation and a strengthening economy largely caught Wall Street off guard. The Fed had previously forecast no rate hikes until 2024.
The Dow Jones Industrial Average tumbled 3.5% last week in its worst week since October, but rebounded 1.7% on Monday as volatility eased. The CBOE Volatility Index (VIX), often called the market’s fear gauge, slid 13% Monday, but investors are still on edge – the VIX is up 9.7% over the past five days.
Recent volatility will continue ahead of the Federal Open Market Committee’s July 28 meeting, write BTIG’s Julian Emanuel, chief equity and derivatives strategist, and Michael Chu, equity strategy associate, in a June 20 note.
Inflation, which the strategists noted recently snapped out of a two-decade-long downtrend, has been a key market driver as commodity prices have surged. Demand has outpaced supply economic activity resumes, bolstered by low interest rates and fiscal stimulus.
The Fed has consistently insisted that these price jumps are "transitory" and will pass, meaning no drastic rate hikes that would hurt stock and bond prices are necessary. That view is the current consensus among fund managers recently polled by Bank of America and is supported by sliding commodity prices.
But the Fed could catch the market off guard by announcing plans to taper bond purchases or bump up interest rates sooner than anticipated.
"If the market either believes that the Fed is insufficiently addressing the inflation threat or the Fed's own wavering on the notion of 'transitory' convince the market that the threat of inflation becoming un-anchored is larger than it actually is," the BTIG strategists write, "… what exactly then happens to the stock market, trading at valuations near prior peaks?"
Stock indexes hover near record-highs but have struggled for direction in recent months as the economic recovery takes center stage in place of the pandemic.
Equity prices outran earnings in 2020 as investors dismissed weak quarterly results and saw generous fiscal and monetary stimulus as reasons to be constructive on stocks, even as the Fed's balance sheet and US government debt ballooned.
That optimism triggered drastic increases in the prices of assets like stocks, commodities, and cryptocurrencies. The trend is exemplified by so-called "meme stocks" pumped on Reddit's WallStreetBets, like GameStop and AMC, whose "valuations have arguably disconnected from standard metrics," the strategists write.
More "meme-ification" madness can resume if the Fed remains accommodative, but further backtracking in July may unwind the action.
The strategists recommend that investors take advantage of this heightened volatility using an options trade known as a straddle, which involves simultaneously buying a put and call option on the same security with the same strike price and date. The trade is suited for big price swings because it profits in either direction as long as the security rises or falls by more than the premium an investor pays.
BTIG recommends buying S&P 500 calls and puts straddled around the 4,250 level that expire July 30, two days after the FOMC's next meeting. A notable move to the upside or downside would make the trade profitable.
Another strategy to bet on higher long-term volatility in bond yields is by purchasing iShares 20+ Year Treasury Bond ETF (TLT) August 146 straddles, which cost $7.20 and have 14.5% volatility based on the June 18 close price of $145.73.
"In order for this trade to be profitable at expiration, TLT must be trading at a level above $153.20 (call strike plus premium paid) or below $138.80 (put strike less premium paid) versus the current level of $145.73," Emanuel wrote.
BTIG expects 10-year US Treasury yields to reach 2% by year's end, up from about 1.48% Monday.