What to Expect When You’re Expecting the Fed – December 2023 edition

It’s here – the last FOMC meeting of 2023.  While the consensus is clearly that no rate change is expected, today’s rate announcement and subsequent press conference has the potential to be quite consequential. 

Markets have flipped from nervous to sanguine since the last FOMC meeting on November 1^st, and it seems impossible to believe that the decision makers at the Federal Reserve failed to notice this change.  Ahead of the prior meeting, stocks had completed their third straight month of declines and 10-year rates had been flirting with 5%. Since then, stocks have largely recouped a quarter’s worth of losses and 10-year rates are heading into the meeting at 4.15%.   During that time, Fed Funds futures reflected a drastic turnabout in expectations.  They switched from modest expectations for another hike, with cuts starting in June or July, and 2-3 expected during 2024.  We now have essentially no likelihood of a further hike, cuts starting in March or May, and 4-5 expected during 2024.

We have questioned whether market expectations have outpaced the Fed’s intentions.  We’ll know soon enough whether the FOMC confirms the aggressive cutting cycle that is currently backstopping market expectations.

As of now, options markets are showing little concern about that prospect.  Seeing VIX trade with an 11 handle yesterday confirmed the lack of demand for volatility protection from institutional investors.  Looking at a more granular level, we see some respect for the idea that today’s events could bring some incremental volatility, but little outright nervousness.  At-money options in SPX expiring today are pricing in a 1.8% move, but that expectation fades very quickly by Friday.  (see the table at the bottom for further context about one- and three-day moves after recent FOMC meetings)

SPX Volatility Term Structure

Source: Interactive Brokers

The IBKR Probability Lab shows symmetrical outcomes for SPX options expiring both today and Friday.  Note that the peaks are just about at-money:

IBKR Probability Lab for SPX Options Expiring December 13^th

Source: Interactive Brokers

IBKR Probability Lab for SPX Options Expiring December 15^th

Source: Interactive Brokers

Finally, we see that skews are relatively typical, with a bias to the downside, though they are understandably quite steep in the short-term:

Volatility Skews for SPX Options Expiring December 13^th (pink), December 15^th (yellow), January 19^th (orange)

Source: Interactive Brokers

We are coming into today’s FOMC meeting with a high level of enthusiasm and few concerns about its sustainability.  SPX is at a 52-week high, accompanied by the sort of RSI readings that have indicated overbought markets – until late last month.  Despite this, few traders seem concerned.

SPX, 1-Year Candles (top) with 9-Day RSI (bottom)

Source: Interactive Brokers

There is often a “secret word” or phrase that traders fixate upon during Chair Powell’s press conferences.  It’s been “disinflation”, “neutral”, and most recently “balance of uncertainties.”  It’s impossible know in advance what today’s trigger might be.  My bets would be placed upon either “neutral”, as in a reminder that Fed has still not yet acknowledged anything other than a tightening bias; or “target” as in a reminder that while we have made excellent progress towards the Fed’s 2% target inflation rate, we’re not there yet.  When might we arrive at that target and how long might it need to persist before the Fed can consider cutting?

Additionally, we will leave you with a reminder that the FOMC may set the tone for today’s press conference with the so-called “dot plot”:

The November meeting did not feature a “dot plot,” the colloquial name for the FOMC’s Summary of Economic Projections (SEP).  In September, the median Fed Funds rate projection for the end of 2024 was 5.125%.  That hardly squares with the 4.26% that is currently estimated by futures markets.  (Though it is indeed up from last week’s 4.07%)  A dot plot that falls well short of current projections could certainly spook markets, and unless Powell is willing to disavow his colleagues’ projections, he will need to spend a fair amount of the press conference explaining why the FOMC’s views are so far off the market’s. 

Ask yourself, which has the greater likelihood?  That the FOMC and Powell will reaffirm the market’s rosy assumptions about rate cuts, or whether they will reassert that while we have made great progress against inflation, we have not yet achieved the 2% objective, and thus it is premature to consider rate cuts until that occurs.  If the former, then by all means remain sanguine about risk assets.  If the latter, perhaps some risk aversion seems prudent.

Buckle up.  We’ll know how things transpire soon enough.  And remember, the first move is often the wrong one.

Source: Interactive Brokers