Will the Fed Tighten in 2019? Potential Low Cost Trades

By Arthur Bass, Wedbush Managing Director

Yes, equities have tanked the past month, and Apple now has competition in China, but employment has been gangbusters and stocks could easily stabilize if President Trump reaches a deal with China. Equities declined in December, but economic statistics are still firm. Markets are currently pricing in 35% probability of an ease this year, versus 80% probability of a tightening in 2019 as recently as three weeks ago.

At current FRA-OIS of 32bp:

  • Fed on hold —> EDZ8 97.28
  • Tighten once —> EDZ8 97.03
  • Tighten twice —> EDZ8 96.78 vs EDZ9 97.385

EDZ9 97.25/97.00/96.75 put fly 4/4.5 works best with one move. EDZ9 97.125/96.875/96.625 put fly 3.25/3.75 both flies have ~-.05 delta, and should hold value for the next few months. I view them as low cost trades for the Fed tightening at least once and maybe two more times.

We have been viewing the lower strike fly as a good “what if” trade for the economy continuing to perform and the Fed moving at least once. With the rally this week, the higher strike fly is also at a reasonably cheap level.

Yes, the Fed could easily be on hold this year, but the Dots from 2 weeks ago said two moves, and with employment still firm, they could come back to them if risk markets stabilize. You can be bullish, but have this position as part of a portfolio position.