The following is a guest post courtesy of Michael Kramer of Mott Capital Management.
Buy the Fed meeting. Sell the Fed minutes.
It may be the name of the game for the stock market. At least since the start of 2022, the minutes have been a cause of concern for markets, while the FOMC meetings have resulted in face-ripping, risk-on rallies. The reasons can seem hard to explain, especially since both the minutes and meetings have had seemingly more and more hawkish tones. But that does seem to be the pattern.
The market’s gyration may be easier to understand than they seem. SpotGamma often refers to these sharp rallies as a “Vanna trade” in their daily notes. At the same time, the SpotGamma HIRO Indicator can often depict the hedging activity taking place ahead of these types of macro events.
Fade The Minutes
Look at the chart above and the timing of the prominent market sell-offs and massive rebounds. The S&P 500 all-time high came on January 4, just one day before the FOMC minutes, and a subsequent drop. The rebound started on January 25, the day of the FOMC meeting, followed by a nearly 5% rally.
Nearly the same thing happened when the minutes were released on February 16. The S&P 500 dropped sharply again, followed by a massive, almost unexplainable rally that followed the FOMC meeting on March 17. Thus far, the release of the minutes on April 6 has led to a modest decline; whether that decline worsens is yet to be seen.
Hedging Activity
This market volatility may be simpler to explain than it seems, having to do simply with managing risk and using the options market. The VIX index, a measure of market implied volatility, seems ideal for measuring this. Typically, the VIX has been at the lower end of its trading range heading into the Fed minutes and at the higher end of that range heading into the FOMC meetings.
It would suggest that the market is simply looking to add protection heading into the FOMC meetings by adding puts to guard against the uncertainty of a Fed meeting. The action of investors buying puts results in Market Makers being short puts. To hedge exposure, the Market Maker will then short futures to remain hedged. As the market moves, Market Makers are forced to continually reposition their hedges. If the markets are falling as more investors buy puts, the more futures Market Makers need to short to stay hedged.
De-Risking Event
Meanwhile, once the FOMC meeting is over, there is a de-risking event, which results in implied volatility dropping. This results in put options losing value quickly, which causes investors to sell their puts and unwind their hedges. This, in turn, results in the Vanna trade, causing Market Makers to buy back their short-future hedges.
For those looking for a short-term market bottom, it may not come until after the FOMC meeting, as investors look to de-risk and unwind their bearish hedges, and the Vanna trade kicks in, giving the stock market another big post-FOMC risk-on rally.
