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Yesterday, the Federal Reserve delivered the hawkish rate cut as widely anticipated. A rate cut by 25bp to 1.50-1.75%, two FOMC members voted against the step and there was one dove (James Bullard) who was content with 25bp rather than 50. As the FOMC monitors “the implications of incoming information for the economic outlook” it no longer acts “as appropriate to sustain the expansion" but "it assesses the appropriate path of the target range". In other words the Fed now sounds neutral and there will be a pause, no further steps to follow this year. The reason behind that: the risks (trade conflict, Brexit) have eased, private consumption remains solid. In view of the Fed’s move towards a neutral approach this is good news for the dollar, and as a result it was able to appreciate significantly immediately after the rate decision.
So why is the dollar now trading at weaker levels anyway? During the course of the press conference Fed chair Jerome Powell eliminated the impression that the Fed might consider rate hikes at some point soon. Things are not going that well after all, and the downside risks for growth persist. Moreover inflation remains too low and according to Powell “we would need a significant rise in inflation before we consider raising rates". The door remains open for another rate cut and as a result the market feels confirmed in its view that another step will follow next year after all. If the data was to deteriorate significantly the Fed would not hesitate to cut rates again.
The position technicals are long and market-depth is low: we recommend tactical duration shorts in 3s. We preview next week’s November refunding. We revise our TIPS breakeven fair value models. Supply/demand dynamics, a weaker coupling to year-end funding stress, and elevated levels suggest FRA/OIS is rich into December: sell Z9 FRA/OIS. Implieds look marginally rich at current levels, as macro risks abate. Sell 3Mx2Y ATMF straddles.
Trade Tips on FX Options and Interest Rate Derivatives:
1) At spot reference: 1.1175 levels, initiated long in 2 lots of EURUSD at the money -0.49 delta put options of 3M tenors, simultaneously, write an (1%) out of the money put option of 2w tenors. Short-legs go worthless as the underlying spot price hasn’t gone anywhere. Any slumps from here onwards are to be arrested by the 2 lots of ATM long-legs.
Those who are sceptic about mild rallies, 3m 1% in the money puts with attractive delta are advised on a hedging ground. Thereby, in the money put option with a very strong delta will move in tandem with the underlying.
2) Stay received EUR/USD 3Mx3M OIS/OIS basis
Receive $50k DV01 3Mx3M (swapstart: 12/09/19, swapend: 03/09/20) EURUSD OIS/OIS basis at -59bp. Courtesy: JPM & Commerzbank
