The Fed's Next Move:
Reading the Signs and Developing a Pre-FOMC Strategy

By Greg Perlin and Mike Marshall   ISSUE 704 | APRIL 2008

The Federal Open Market Committee meeting is coming up on April 29-30, 2008, and Fed policymakers must decide where interest rates are headed next. The Fed has lowered its key short-term lending rate, known as the Fed funds rate, six times since September 2007. It is now at 2.25 percent. But as commodities from crude oil to gold to rice reached record highs this spring, the question on many people's minds is whether or not the easing rate cycle will continue given the environment of rising prices we are in.

With inflation running at progressively higher rates, the Fed may be forced to hold rates steady or even possibly raise rates at the next meeting. We will attempt to point out the signs that the markets are giving us, and why we believe the Fed will be forced to raise rates in the near term. It may not happen at this month's meeting, but read the tea leaves from the Fed's statements as to when a big shift in policy may be coming. It is likely to impact markets across the board; not just financials, but many commodities too.

Below is a chart of the stated Fed funds rate dating back to 2001. As one can plainly see, the Fed funds rate had been steady at 5.25 percent from June 2006 through August 2007. Then the Fed cut the rate by half a percent on September 18, 2007.

Now let's look at a weekly chart of the June 2008 Eurodollar futures. Eurodollar futures are short-term interest rate contracts that tend to be very responsive to Fed rate decisions. The breakout to new highs from the consolidation period on the chart below coincides with the Fed's decision to begin cutting rates in September 2007. Recent price action in the chart shows that the June Eurodollar futures market is pricing a future rate hike, or at the very least, and end to the easing cycle. From working in the interest rate trading pits at the Chicago Board Of Trade, we know the importance of reading the signs that are given.

A Pre-FOMC Trading Strategy

Fed policy meetings can be volatile times for traders, and many step aside until the dust settles. However, volatility also brings opportunity, and there are some strategies you can consider in the days leading up to the Fed's meeting decision. We currently recommend buying bear put spreads in the December 2008 Eurodollar futures, and financing them by selling the out-of-the-money calls, as follows.

Buy 1 Dec 08 Eurodollar 9700 put
Sell 1 Dec 08 Eurodollar 9600 put
Sell 1 Dec 08 Eurodollar 9800 call

We recommend buying the spread at 20 ticks or better, so your cost (not including commissions) is 20 x $25 = $500.

Risk: Unlimited. In order to finance the put spread, you would sell a naked 9800 call. The trade off for a cheaper position is that the risk of loss is potentially unlimited. So this is not a strategy for the more conservative traders.

Max profit potential: The maximum potential profit would be $2,000, minus your commission costs. The calculation is 100 (potential profit from 9600/9700 put spread) – 20 (initial outlay for the option spread) = 80 ticks: 80 x $25 = $2,000.

This is just one idea to consider. We are always willing to tailor specific investment strategies for each individual investor. Every trader has a different risk tolerance and should trade according to his or her risk parameters. We strongly urge that traders interested in these strategies to call us. In our experience, we have found option spreads of this sort are best executed when dealing directly with floor brokers. Here at Lind-Waldock we can provide our clients with the direct floor access needed to fill these orders.

Greg Perlin is a Senior Market Strategist at Lind Plus, Lind-Waldock's broker-assisted division. He can be reached at 800-437-4189 or via email at gperlin@lind-waldock.com.

Mike Marshall is a Market Strategist at Lind Plus. He can be reached at 800-437-4189 or via email at mmarshall@lind-waldock.com.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

You can hear market commentary from Lind-Waldock market strategists through our weekly Lind Plus Markets on the Move webinars, as well as online seminars on other topics of interest to traders.

Futures trading involves substantial risk of loss and is not suitable for all investors.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.

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