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Three Tails Today: Fed, Fiscal and Frexit

If we look for macroeconomic and political conditions today that have the potential to result in large moves in the markets, three interrelated events immediately come to the forefront.

The first is the Fed. Looking out to next year, will the monetary policy path end up being too hawkish, or will it in retrospect have been too dovish? Second, will the massive fiscal promises made by the new administration in the U.S. be delivered “on schedule”, or will there be disappointment? Finally, will 2017 see a continuation of global political change in the form of “Frexit” or will the EU stabilize?

For our perspective, the questions that need to be answered are these: What will be the precursory indicators that investors can follow to track the changing probabilities of these tails? What would be the impact of these tails on the markets? How can investors position their portfolios today in light of these events for potential asymmetric rewards?

Starting with the Fed, our view is that the risks at the moment are currently balanced between a too hawkish stance and a too dovish stance. Signs of increasing hawkishness are market probabilities that begin to reflect more than three tightenings in 2017, signals of potential inter-meeting rate rises, or a rate rise exceeding 25 basis points at one of the meetings. On the flip side, signs of increasingly easy policy are markets discounting less than three tightenings, the invocation of external factors on monetary policy to make sudden dovish pauses, or a change in the makeup of the policy making body.

Looking at the probabilities as implied by Fed Funds futures markets and options on Eurodollar futures contracts, these left and right tail probabilities at the moment seem to be roughly balanced. But keep a close eye on the expected probability of the Fed Funds rates being above 1.5% by next January. If this probability — which is around 20% today — starts to rise sharply, the bond markets could be in for a surprise.

The new administration came in with the promise of massive fiscal stimulus. As echoed in the President’s speech to Congress, this stimulus could arise from infrastructure spending and tax cuts, as well as cross-border tariffs and a reduction in regulations. Given the makeup of Congress, and this administration’s willingness to make decisions, one would have to grant that the likelihood of some of this stimulus actually taking place is reasonably high. The signs to watch that the market’s expectations are too optimistic are reversals in some sectors that have been outsized beneficiaries since the election. Banking, biotech, small caps, and domestically focused sectors stand out as providing the best indicators from the markets.

Finally, and possibly packing the most punch, is the risk of Frexit and its impact primarily on the Euro currency. Instead of forecasting probabilities, let us do a pre-mortem exercise. If we were to move the clock forward and look back, what would have been the proximate signs of the Euro trading below parity in six months from now? The polls today show a 20%-30% chance of the far-right party winning the French elections. Survey markets show a tail probability of the Euro currency trading below parity of the same rough magnitude. Putting in unconditional likelihoods of a slightly more hawkish Fed and as-expected fiscal stimulus, our computations suggest that a very small increase in the probability of a Le Pen victory is all that is needed to send the Euro below parity. However, this seems to be the consensus, and markets rarely follow the consensus in a straight line.

These three events are obviously related through their impact on interest rates, equity market response, and currency market reaction. Given the extremely favorable volatility, skew and correlation markets, all of these views on tails can be expressed today in asymmetric form in the options markets.

Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, a California-registered investment adviser and a CFTC-registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.

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