I came across the following visual of the Bank of Canada’s inflation estimates vs actual prints in the Canadian Consumer Price Index (CPI). Surely, we could create a similar chart for the US Fed’s inflation forecasts.
Source: https://www.bnnbloomberg.ca/bank-of-canada-renews-2-inflation-target-adds-jobs-to-mandate-1.1694989
If you’ve been involved in markets for any period of time, you’re more than aware of the Fed’s “inconsistent” forecasts. And often, it’s the market’s pricing that leads the Fed in any case.
So much so, that former Chief Economic Adviser to Allianz, Mohamed El-Erian recently called the Fed’s labeling of US inflation as “transitory” as its worst inflation forecast ever. To cite him directly,
“The characterization of inflation as transitory – it’s probably the worst inflation call in the history of the Federal Reserve.” – Mohamed El-Erian
As we go into tomorrow’s US interest rate meeting, market expectations are for US Fed Chair Jay Powell to keep US interest rates unchanged while announcing the start of the tapering of the pandemic-era stimulus program. However, these expectations have only strengthened after Friday’s better-than expected November US CPI figures (CPI 6.8% YoY; 0.8% MoM).
US Fed Meeting Market Probabilities
Source: https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
Powell’s Last Chance
Arguably, Powell’s and the Fed’s reputation has already been tarnished by not getting the inflation call even remotely correct. It’s also arguable that it’s precisely their job to make such forecasts with some level of accuracy. Powell will have to deliver a strong (and correct) message to the market that US interest rates are going up – albeit slowly.
If he misses this opportunity to clearly spell out that inflation is here to stay and that the Fed is going to adjust monetary policy soon, markets could really pick up.
Short Term Trading/Hedging Idea
If you are inclined to hedge and/or trade ahead of Wednesday’s US Fed meeting, the following 3-month long USDCAD put spread provides good protection against USD weakness. Also, with higher implied volatility (IV) going into the announcement, vanilla USD puts are not attractive given the potential IV crush after Wednesday.
BUY 1M USD put/CAD call at 1.27 expiring March 14, 2021
SELL 1M USD put/CAD call at 1.25 expiring March 14, 2021
Net cost = 0.75%-1% USD; Reward/Risk = 2:1 (approx.)
3-Month USDCAD Implied Volatility
Source: https://widget2.sentryd.com/widget/#/15490A29-95E3-4296-999E-28D0B35E0D12/USD-CAD/4
Until next time…
Alex
Alexander Grant, FRM is Olympia Trust CGP’s Head of FX Options Trading. He can be reached at granta@olympiatrust.com if you have questions.
Information provided is for informational purposes only. It is not investment or trading advice, or solicitation for the purchase or sale of any financial instrument.
