Fed Day Volatility- Looking through the Forest to see the Trees

Markets are gearing up for another Fed decision, with uncertainty looming large. In recent years, the Federal Reserve has worked to improve its communication and transparency to avoid surprising markets. However, this meeting presents the highest level of uncertainty regarding the Fed's next move since 2015. 

While most market participants agree that a rate cut is imminent, the debate centers around whether it will be a 25 or 50-basis point reduction. The size of the cut will undoubtedly influence market volatility, but investors should also focus on other key factors. These details could provide insight into the Fed's future policy direction and, more crucially, the overall health of the U.S. economy and financial markets.

Investors should keep in mind that there is a significant amount of uncertainty surrounding this Fed meeting, which adds complexity to market reactions. The notional value of options, particularly with Friday's triple witching, will contribute further to market volatility. While it's important to let events unfold, investors should stay focused on the broader economic cycle. We have provided a list of ETFs that are positioned to benefit in the long run. Instead of trying to navigate the short-term market swings, it's wise to keep an eye on the bigger picture and seek out long-term opportunities that align with the cycle.

25 or 50 Basis Points? 

The upcoming Federal Reserve meeting has sparked significant debate over whether the central bank will opt for a 25 basis point (bps) or 50 bps interest rate cut. While futures markets, according to the CME FedWatch tool, currently price in around 115 bps worth of cuts by the end of the year, there is no clear consensus on the immediate path. The Fed Fund Futures point to a 61% chance the Fed will cut rates 50 basis points. 

Source: CBOE

Recent economic data plays a critical role in shaping these expectations. The August Consumer Price Index (CPI) rose 2.5% year-over-year, marking a slowdown compared to July's 2.9%, and providing evidence that inflation is cooling. Additionally, the Producer Price Index (PPI) also posted its smallest year-on-year increase since February. These figures may support the case for a 25 bps cut, as they indicate moderating inflation without any signs of significant economic distress. Meanwhile, the labor market remains relatively stable, with unemployment dipping slightly to 4.2% in August, signaling that the economy is not yet in a dire state warranting drastic policy action.

Despite the debate, this meeting is more about the Fed easing off the brakes on its aggressive tightening cycle rather than hitting the gas on monetary stimulus. Chair Jerome Powell's comments at the Jackson Hole symposium suggested the Fed is committed to a cautious, data-driven approach, with Powell likely to reiterate that every meeting remains live for further cuts. This measured approach is consistent with the Fed's desire to avoid appearing panicked or risk undermining its credibility by rushing into larger cuts without clear economic justification.

We are not concerned about whether the Fed goes 25 or 50. The bigger issue will be the message delivered for how the central bank will proceed in the coming months.

The Dot Plot

The Fed dot plot represents the interest rate projections of Federal Reserve policymakers over the next few years, showing their individual expectations for future federal funds rates. Each dot corresponds to a member's forecast for where they believe rates should be at the end of the current year, as well as in the coming years and longer term. It serves as a tool to gauge the Fed's anticipated path for monetary policy based on economic conditions, though it is not a firm commitment.

Source: Federal Reserve

The chart shows the Fed dot plot from the June meeting. It highlights that eight members anticipated the federal funds rate would end 2024 in the 4.75-5.00% range, seven expected it to be in the 5.00-5.25% range, and four projected the rate would remain at the current 5.25-5.50% level. This indicates that eight of the 19 members foresaw a 50 basis point reduction, seven were expecting only a 25 basis point cut, and four believed no rate cuts would be necessary this year.

Currently, market participants are pricing in 100 basis points of rate cuts, with expectations of a 25 bps cut today, 50 bps in November, and another 25 bps in December. Investors will be watching to see if the majority of the dots shift toward the 4.25-4.50% range, aligning with the market's forecast. If the majority of dots stay above that level, it may spark concern that the Fed is moving too slowly in easing rates.

With just over three months left in 2024, attention will also be on the Fed's dot plot projections for 2025 to get a clearer sense of future rate cuts.

The Summary of Economic Projections

The Federal Reserve's Summary of Economic Projections (SEP) provides insights into the central bank's outlook on key economic metrics such as GDP growth, unemployment, inflation, and the future path of interest rates. These projections offer a glimpse into how Fed officials expect the economy to perform and influence their decisions on monetary policy. The SEP is particularly important for markets as it helps shape expectations for future rate moves and economic conditions.

The Fed's Summary of Economic Projections (SEP) from the June meeting provides a detailed look at key economic metrics. In terms of GDP growth, the Fed's projection for 2024 remained steady at 2.1%, while estimates for 2025 and 2026 were slightly lower at 2.0%, aligning with the March projections. These growth expectations will be closely monitored, especially considering concerns over a potential economic slowdown. At the time, the Fed projected the unemployment rate is expected to rise slightly to 4.0% in 2024, with further increases to 4.1% in 2025 and 2026, again matching the March estimates, reflecting a cautious outlook on the labor market. Of course, the August BLS report showed Unemployment at 4.2% already. This will need to be revised higher for 2024 and probably 2025. If we see that aggressively pushed higher and the Fed only moves 25 bps, that could raise a red flag that the Fed is behind the curve. 

A key change in the SEP was the Fed lowering its inflation outlook, an important signal to markets. The Personal Consumption Expenditures (PCE) inflation rate for 2024 was projected at 2.6%, down slightly from 2.8% in March, while 2025 and 2026 projections also showed slight reductions. Similarly, Core PCE inflation—an even more closely watched metric—was projected to decline from 2.8% to 2.6% in 2024, with longer-term projections signaling a return to the Fed's target of 2.0%. This downward adjustment in inflation expectations is significant, as it shows the Fed believes price pressures are easing, which could influence future rate decisions. The Fed will walk a fine line here as people would like to see the restrictive policies are working but they do not want any deflationary alarms. 

One of the most critical metrics to watch is the Federal Funds rate, which directly ties into the dot plot projections. The SEP from June projected the Federal Funds rate at 5.1% for 2024, rising slightly from the March estimate of 4.6%, with rates gradually declining to 4.1% in 2025 and 3.1% in 2026. These projections suggest the Fed anticipates maintaining relatively high rates in the near term to combat inflation, before easing into 2025 and beyond. Any changes in these projections could provide insight into the Fed's longer-term strategy, particularly in terms of how aggressive future cuts might be.

The long run projection for the Federal Funds rate is also essential, as it represents what the majority of Fed members see as the neutral rate, or the level that supports stable inflation and employment without overheating the economy. In June, this was projected at 2.5%, consistent with March projections. This long-term view is crucial for understanding where the Fed expects rates to stabilize once inflation is under control and economic conditions normalize. It will also define how far above neutral the Fed believes it is currently. 

Investors will be paying close attention to any adjustments in these projections, particularly the Fed's outlook on growth, inflation, and rates. Any shifts in these areas could have significant implications for the Fed's monetary policy and market expectations heading into 2025.

Market Reactions to Rate Cut Cycles

Source: Goldman Sachs

The table provides data on the S&P 500's performance following the first rate cuts by the Federal Reserve, categorized by the size of the rate cut (50 basis points or 25 basis points with one 100 bps cut) and whether a recession followed within the next 12 months. 

For rate cuts of 50 basis points, there were three instances: September 1984, November 1987, and September 2007. In the first two instances, the cuts did not lead to a recession, and the S&P 500 returned 1% and 2% in the first three months, 9% and 6% over six months, and 14% and 9% over 12 months, respectively. However, in September 2007, the cut led to a recession, with negative returns of 3%, 11%, and 18% over 3, 6, and 12 months, respectively. Of course, this preceded the Great Financial Crisis which created extensive pressure on financial markets. 

Grouping the 25 basis point cuts, the table lists four instances: June 1989, July 1995, September 1996, and July 2019. In the first three instances, the cuts did not lead to a recession within 12 months. The S&P 500 returned positive results in each case, with 9%, 6%, and 20% increases over 3 months; 9%, 13%, and 27% over 6 months; and 17%, 22%, and 23% over 12 months, respectively. In the case of July 2019, a recession did follow within 12 months, but the S&P 500 posted gains of 2%, 9%, and 12% over the same periods. The global pandemic drove this recession. 

It is important to highlight that in the last three times the Federal Reserve initiated a rate-cutting cycle (2001, 2007, and 2019), a recession followed within the next 12 months. In January 2001, a 100 basis point cut was followed by the S&P 500 falling 18% over three months, 8% over six months, and 12% over 12 months. Similarly, in 2007 and 2019, despite different cut sizes (50 bps and 25 bps), recessions ensued, with mixed market reactions. Extenuating circumstances drove each one of these recessions. Perhaps 2001 provides the greatest mirroring as the Ai bubble can be likened to the Internet bubble although valuations are certainly more in line this time. 

Overall, while 50 basis point cuts have generally led to more volatility and negative returns during recessions (notably in 2007), 25 basis point cuts tend to be followed by strong positive S&P performance when no recession occurs. The most recent instances suggest that recession risks remain elevated following rate cuts, regardless of size, with 2001, 2007, and 2019 showing a clear trend of recessions within the next year. This is why it will be important for Powell to couch a rate cut under the pretense that the Fed is simply too restrictive and has room to move. 

What Do Options Skews Tell US

Source: Nomura

The chart above highlights the Put Skew heightened volatility surrounding the upcoming Federal Reserve decision. Specifically, an options strategy known as an at-the-money straddle is pricing in the largest potential move since March 2023, when markets were reeling from the collapse of Silicon Valley Bank. This reflects significant uncertainty around the Fed's decision, with traders debating the size of a potential rate cut. 

The VIX, often referred to as the fear gauge, remains subdued at 17, below its long-term average, yet the VVIX, which measures demand for hedging VIX volatility, stays elevated above 100. This shows that while broad market fear is low, demand for crash protection remains strong, signaling apprehension about potential sharp moves.

Investors employing volatility strategies like straddles are hoping to capitalize on a substantial move in either direction following the Fed's decision. A straddle requires a move of around 1.2% up or down in the S&P 500 for profitability. This suggests that traders are bracing for significant market movement, even though it's unclear if the move will be positive or negative. Depending on the size of the rate cut and Federal Reserve Chair Jerome Powell's comments, the market could react strongly, and traders holding these positions stand to profit from volatility in either direction.

Adding to the potential market turbulence is the upcoming Triple Witching on Friday, when options and futures contracts expire. This quarterly event often amplifies volatility, as large volumes of options linked to individual stocks, ETFs, and indexes are settled. The convergence of the Fed's decision and Triple Witching is likely to create a significant catalyst for market swings, leaving options traders in a prime position to take advantage of sharp price movements in the coming days.

ETFs to Watch

Here are five interest rate-sensitive ETFs to watch around the Fed decision:

1. iShares 20+ Year Treasury Bond ETF ($TLT(TLT)) – Tracks long-term U.S. Treasury bonds, which are highly sensitive to interest rate changes. Lower rates mean higher bond prices which will boost the TLT. We would watch the 2024 and 2025 path in the Dot Plot to gauge the potential upside in this instrument. 

2. Financial Select Sector SPDR Fund ($XLF(XLF)) – Focuses on the financial sector, including banks, which can be affected by changes in interest rate policy. Financials have pressed higher into the report. If we see Powell tight a strong economy and solid financial conditions, then this would be a group that should outperform into the end of the year. 

3. Vanguard Real Estate ETF ($VNQ(VNQ)) – Real estate investment trusts (REITs) are interest rate-sensitive due to their reliance on borrowing and mortgage rates. Real Estate names have rallied to 52-week highs ahead of the Fed decision. If we see the markets reverse following the Fed meeting, then we would look for this to pullback. Traders can either try to short the group or wat for a pullback to the $91 area to buy it. 

4. iShares U.S. Home Construction ETF ($ITB(ITB)) – Homebuilders are influenced by mortgage rates, which move in response to interest rate changes. The ETF is pressing above the $120 level ahead of the report. Housing data will remain important but expectations for the housing market to improve as mortgage rates slide will be high. In addition, the housing market has been a focal point for both candidates, suggesting additional stimulus for the homebuilders. 

5. iShares iBoxx $ Investment Grade Corporate Bond ETF ($LQD(LQD))– Tracks investment-grade corporate bonds, which are affected by changes in the cost of borrowing. Given the volatility expected, this ETF sets up nicely as a safe haven play for investors, especially if Powell highlights the strength of the overall economy. The ETF has rallied 8% ahead of the decision and has room to run. 

These ETFs tend to experience volatility around Fed decisions, given their sensitivity to changes in interest rate policy.