Options Market Braces for Volatile Fed Interest Rate Decision

As the Federal Reserve's July policy meeting approaches, anticipation is building among investors, economists, and policymakers. With the Fed expected to hold interest rates steady at the current target of 5.25%-5.50%, market participants are closely watching for any signals about the timing of the next rate cut.

According to data compiled by Market Chameleon, market-predicted movements of the fund tracking the S&P 500 from 9:30 AM to the close on Federal Reserve interest decision days have often underestimated actual market movements since October 2023. An analysis of the pricing of straddles for the S&P 500-tracking fund reveals that the options market has been underestimating market movements 57% of the time and overestimating them 43% of the time over the past seven occurrences.

On average, the S&P 500 has experienced a 1% up move on interest rate decision days when it has ended higher, as observed in three of the up days. Conversely, on the four down days, the index has shown an average decline of 0.65%.

Recent data indicating that inflation is edging closer to the central bank's 2% target has bolstered expectations that the Fed might open the door to rate reductions as soon as September. The Fed’s preferred personal consumption expenditures price index showed a 2.5% year-over-year rise in June, down from a peak of 7.1% in 2022, suggesting that price pressures are easing.

Ahead of the meeting, former St. Louis Fed president Jim Bullard noted that with inflation moving closer to the target, policymakers could signal a shift in their stance. "A slight change in the statement, perhaps describing inflation as 'moderately elevated,' would send a major signal to markets," Bullard said. This policy meeting, therefore, holds significant implications for the market, especially given the sizable gap between the July meeting and the next one in September.

In the derivatives market, traders are not just expecting a rate cut; some are betting on more aggressive moves. Options markets are pricing in at least two quarter-point rate reductions by the end of the year, slightly more than what the Fed has indicated. Speculation about a bold half-point cut in mid-September has gained traction among some traders, although this remains an outlier scenario. The increasing concern that the labor market might crack under the pressure of two-decade-high benchmark rates is fueling these bets.

The open interest in Fed funds futures for September, October, November, and December has climbed to new highs as traders position for potential rate cuts. Specifically, September and October contracts saw a 12% and 13% increase in open interest, respectively, reflecting heightened expectations for Fed easing by year-end.

The bond market has also been reacting to these developments. Treasuries have advanced for the third consecutive month, with investors fully pricing in at least two quarter-point rate reductions this year. This has led to a significant increase in Treasury futures, particularly in five-, 10-, and Ultra 10-year contracts, aligning with new commitments to yield-curve steepening wagers.

The backdrop of easing inflation and potential rate cuts has created a more favorable environment for bonds, pushing yields lower and prices higher. This trend suggests that bond investors are increasingly confident that the Fed will move towards a more accommodative stance in the near future.

"If VVIX stays elevated, even with lower VIX, this will suggest that the market expects volatility to swing around over the next few weeks" amid catalysts of earnings, growth and politics, Tanvir Sandhu, Bloomberg Intelligence's chief global derivatives strategist, wrote Friday in a note.

The S&P 500's implied volatility for the next week surged to almost 2 points above the expected volatility two weeks from now, the largest gap since June. This suggests that traders are bracing for significant market movements around the Fed's announcement. Options are pricing a 1.1% move in the S&P 500 around the Fed meeting, which, if realized, would be the largest FOMC-day straddle breakeven since March 2023.

Citigroup strategists, led by Stuart Kaiser, noted that while the FOMC event might seem secondary to earnings and payrolls data, there is always room for the Fed to surprise the market. "There is always room for the Fed to surprise," Kaiser wrote, emphasizing that the upcoming week's events could lead to significant market shifts.