Trade The August 2012 FOMC Meeting - Buy VIX Calls

Includes: DGZ, GLD, SH, SPY
by: Varun Bahl

The markets lately have been behaving odd. On July 19, when there was a flood of bad macro-economic data, the S&P 500 Index (SPX) managed to actually move up! Among the bad economic data was a Spanish government bond auction that caused Spanish 10-year bond yield to move above the magical 7% mark—the yield at which Ireland, Greece and Portugal asked for a bailout.

Weekly jobless claims came in significantly worse at 386,000, compared with an expected consensus of 365,000. To top that off, existing home sales (which make up 80% of home sales in the U.S.) came in at 4.37 million versus a consensus number of 4.65 million. And if the above-depressive data hasn't already made you liquidate your entire equity portfolio, on July 19, Philadelphia Fed Survey printed a number of -12.9, substantially lower than the consensus of -8.0, signaling more contraction in the mid-Atlantic manufacturing sector.

So what did the SPX do in light of all this gloom—it rallied! Curiously enough, gold (SPDR Gold Trust ETF: GLD) also rallied.

So why did the markets do so? They have put their faith in Helicopter Ben! The market is expecting the Federal Reserve (Fed) to launch another round of quantitative easing (QE3). Given QE involves the buying of treasuries by the Fed, is considered inflationary, and likely to promote growth, QE expectations cause the market to bid up treasuries, gold (as an inflation hedge) and the SPX. This is driving up the SPX and gold, despite such bad data.

The media is rife with speculation that QE3 could come as soon as the August 1 FOMC meeting. Also, starting May 2012, there has been strong correlation in the movements of 10-year treasury futures and SPX (Figure 1). Gold futures and SPX (Figure 2) have also been moving in lock-step since April 2012. Additionally, a recent Reuters poll suggests that 70% of the economists from 16 primary broker-dealers expect QE3 this year.

Click to enlarge

Figure 1: S&P 500 Index vs. US 10-year Treasury Futures

Figure 2: S&P 500 vs. Gold Futures

So what happens if the Fed does not announce a QE on August 1? Well, the SPX goes down along with gold. And what are the chances that the Fed will not give QE3 on August 1? I'd say very high!

The Fed announced the extension of Operation Twist on June 20 to last through December 2012. Given this decision, any responsible central banker would want to observe its effects for at least a few months before deciding if more monetary easing is needed. I certainly do not except such recklessness from Bernanke.

Additionally, announcing another QE just one month after announcing the extension of Operation Twist will put a serious dent in Bernanke's credibility. First, it will cause investors to second guess the judiciousness of this decision closely on the heels of the one on June 20. Second, it will cause significant political backlash, with fingers pointing that he may have done so to help prop up the economy just before the elections to help Obama's reelection prospects.

The Trade: In light of the above factors, I do not expect QE3 to come on August 1. Hence, I would recommend playing the FOMC meeting by positioning for a decline in the SPX. A few ways to play this would be to short the SPDR S&P 500 Trust ETF (NYSEARCA:SPY), short GLD, or what I am doing—buy at-the-money December S&P 500 Volatility Index (VIX) calls.

The VIX currently is at an exceptionally low level of 15.45. I expect it to not go much lower from here even if the market rallies. On the other hand, it typically rises sharply when the SPX falls. Hence, the risk-reward in the VIX option trade is pretty good. I do expect some time decay to eat away the options value through August 1, but buying a long-dated option like December 2012 minimizes this decay loss.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long December 2012 VIX calls

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