Trade tensions are easing with two major trade framework deals reached with Japan and the EU. Talks are currently taking place in Sweden to extend the trade truce between the US and China, which currently expires on August 12.
The negotiations began on Monday and are expected to continue, raising the likelihood of an extension. However, there remains a small risk that an agreement may not be achieved. Additionally, attention is on the Federal Open Market Committee as a more hawkish statement might surprise the markets.
Indicators of Economic Health
No rate cut is anticipated, but there is concern about complacency. The US labour market shows few signs of slack, and there are indications of upward pressure on core inflation. The S&P 500 (SPX) remains strong, yet there is debate over whether this is due to actual strength or complacency, as seen in the daily candle patterns.
With framework deals reached with major partners like the European Union, to which the U.S. exported over $336 billion in goods last year, geopolitical jitters are subsiding. This environment suggests a potential decline in implied volatility, making strategies that profit from time decay, like selling out-of-the-money options, seem attractive. We believe this relative calm presents opportunities to collect premium.
The market appears to be pricing in a positive outcome on the ceasefire extension talks with China. This creates an asymmetric risk profile, where a failure to agree would likely cause a much larger downward move than the rally from a successful extension. Therefore, holding long positions without a hedge through this period carries significant downside risk.
The Need for Strategic Hedging
We are most concerned about the complacency surrounding the Federal Open Market Committee. The latest Non-Farm Payrolls report showed a robust 272,000 jobs added in May, while core inflation remains elevated at 3.4%, suggesting the underlying economy is too strong for a dovish pivot. The risk is that the chairman’s statement will be more aggressive on fighting inflation than the market currently expects.
Given this risk of a hawkish surprise, we believe buying protection is both prudent and inexpensive. The CBOE Volatility Index, or VIX, has been trading near a historically low level of 13, signaling that option premiums are cheap. Purchasing out-of-the-money puts on the S&P 500 or VIX call options provides a cost-effective hedge against a market downturn.
The strength shown in the daily candles could be masking this underlying fragility. We have seen this before, such as the sharp market sell-off in the fourth quarter of 2018 after a Fed meeting was perceived as too hawkish. A disciplined derivatives trader should therefore be positioned for a potential pullback if his press conference spooks investors.
