The probability of the June 14th Federal Reserve meeting concluding with a 25bp increase in the Fed Funds rate topped 90% according to Fed Funds futures data this week, increasing from only a two thirds probability in early May. ETF traders reacted to this new data by rebalancing their exposure to fixed income, gold and the VIX.
Over the past week, short activity in volatility and interest rate related ETFs traded in a single-minded direction. Short interest in lower grade fixed income ETFs declined while shorts increased their holdings in higher grade bond ETFs along with gold and gold miner ETFs. Along with the shorts’ flight to investment grade vehicles like U.S. treasuries and gold, they are also shorting volatility by buying to cover their inverse VIX ETF bets and adding to their short VIX ETF positions.
ETF investors are forecasting that the almost certain 25 bp increase in the Fed Funds rate will negatively affect the prices of both the short end and long end of the U.S. Treasury yield curve as well as higher rated corporate bonds. Interestingly, by covering their high yield and REIT shorts, they anticipate minimal downward price pressure on lower rated fixed income securities.
With gold rallying to over $1,275/oz. since the beginning of May and nearing its recent high of $1,290/oz., short sellers are increasing their bets that this short term rally will peter out and retrace some of its gains. With U.S. inflation rates declining since February, the need to hold gold as an inflation hedge may be even more diminished if the Federal Reserve deems it is safe enough to raise its rate by 25bps.
Lastly, we are seeing short sellers believing the recent decline in the VIX index will continue as they close out some of their Inverse/Short VIX ETF positions and short the Long VIX ETF instead. The implication being that along with a increase in the Fed Funds rate comes a drop in overall market volatility – the Fed would not raise rates if the overall economic situation was perilous. In fact, if the Fed doesn’t raise rates the implication would be that there is something amiss in the matrix. At a 90.6% probability rate, it’s safe to take the red pill and stay in Wonderland.
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Head of Research, S3 Partners
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