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How to Trade a June Rate Hike

Short-term bulls should prepare for a pullback if the Fed hikes rates this week

Senior Vice President of Research
Jun 11, 2018 at 8:40 AM
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We enter standard June options expiration week with the expectation that numerous headlines will serve as day-to-day market drivers, beginning with developments from the Friday and Saturday G-7 summit in Quebec, where trade and tariffs will likely take center stage. A historic summit is also on the schedule for June 12 in Singapore, when President Donald Trump will meet with North Korean leader Kim Jong-Un to discuss sanctions relief in exchange for Pyongyang's denuclearization.

But the most important event on next week's calendar for investors is likely to be Wednesday's Federal Open Market Committee (FOMC) decision on interest rates. FOMC policy decisions have had a clear and obvious impact on the short-term direction of the stock market since December 2015, which marked the first of multiple rate hikes in the current cycle. Expectations are high that the Fed will again raise rates, as fed funds futures players are pricing in a 91% probability of a 25-basis point hike, per data from CME Group.

"One scenario is the SPY rallying into mid-June and testing the mid-March highs at $280... Currently, fed funds futures players are factoring in a 100% probability of a rate hike on June 13. If the market rallies into this meeting, I could see a scenario in which the sentiment landscape is not nearly as negative relative to that which preceded the May 2 FOMC meeting. In other words, market participants could become more comfortable with stocks on the eve of a June rate hike, which has tended to precede weakness in stocks the following month."
-- Monday Morning Outlook, May 14, 2018

  "Stock Investors Turn More Optimistic"
-- The Wall Street Journal (subscription required), June 8, 2018

The SPDR S&P 500 ETF Trust (SPY - 278.19) has rallied toward the $280 level since mid-May, as I anticipated per the first excerpt above. The ingredients were in place for a rally, as the FOMC held rates steady at the early May meeting, which is circled in green below. As I have said before (and as quantified in the accompanying tables), the market's best days during the current policy-tightening cycle have occurred after decisions by the Fed to hold rates steady.

spy daily with fed meetings circled

Moreover, the SPY had just experienced a technical breakout above a trendline connecting lower highs and above its Fed-day closing level in late-March, which had served as resistance in the weeks following a rate hike (circled in red on the chart). Additionally, there was a lot of short-term negative sentiment on equities ahead of the May FOMC meeting, which was in the process of being unwound -- implying selling pressure was switching to buying power.

Ironically, short-term market participants have turned positive on stocks just ahead of this Wednesday's FOMC meeting. Per the tables immediately below, note that stocks have struggled in the month after a rate hike during the current tightening cycle -- with a notable exception being December 2017, when tax cuts "Trumped" Fed policy.

post-fed spy returns since dec 2015

Such enthusiasm among investors leaves stocks vulnerable to underperformance or a pullback, particularly if the Fed raises rates as expected, and if past is prologue regarding typical SPY behavior in the month following a rate hike. Ahead of the early May meeting, as you can see on the chart below, market participants were distinctly more negative on stocks, as reflected by the relatively high equity-only, buy-to-open put/call volume ratio.

equity put call ratio ahead of fed meetings

For what it's worth, fed funds futures players were placing very low odds on a May rate hike, and they were correct. So the short-term pessimism going into the early May FOMC meeting was misplaced, but now the risk to short-term market bulls is optimism ahead of this week's Fed meeting.

Going into June expiration week, heavy call open interest is overhead at the SPY 280 strike. The volume at this strike has been a mix of buy-to-open and sell-to-open activity, so there is a possibility that there will be a lot of dancing above and below the strike if the SPY visits this level in the next couple of days.

spy june 2018 options open interest by strike

With the SPY just below its March highs and optimism coming into the market over the past few weeks, short-term bulls should be prepared for a pullback or underwhelming price action if the FOMC raises interest rates. Therefore, look to reduce your long position size on a rate hike, and/or look for opportunities on the short side if you see individual stocks breaking below key support levels.

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