Fed-Induced Market Sell-Off — Hedge Your Portfolio With Put Options
- Investors assume the Federal Reserve will cut rates next week.
- Gross domestic product showed 3.1% growth in the first quarter.
- A growing economy and healthy consumer spending may keep the Fed from cutting rates.
- Hedge your portfolio for the uncertainty in rate cuts with put options.
Right now, the markets are making one huge assumption. They are predicting the Federal Reserve will cut rates next week.
And the assumption gives the markets a false sense of hope. If the Fed fails to deliver on that assumption, it’ll be a major disappointment for investors and possibly the start of a market sell-off.
While the economy and consumer spending are casting doubt on the possibility of further rate cuts, the assumptions haven’t changed.
But the truth is that lowering rates in a growing economy doesn’t make sense.
Let’s go over why the Fed may not cut rates next week, and the precautions you need to take for it.
5 Reasons the Fed May Not Cut Rates
Watch my video below to learn more about why the Federal Reserve may not cut rates.
The Fed is an independent institution in charge of ensuring two things — maximum employment and stable prices. To do this, it adjusts interest rates.
When a lack of economic activity is inhibiting economic growth, the Fed lowers interest rates to encourage consumer spending and put money back into the economy.
And when the Fed needs to slow down the economy and keep a moderate level of inflation, it will raise interest rates.
Now, there are five reasons why I believe the Fed won’t lower interest rates:
- First-quarter gross domestic product clocked in at 3.1% growth. That’s the third highest growth for the U.S. economy in the last 14 quarters.
- Retail sales for June came in positive and above expectations. This shows that consumer spending is very healthy.
- The Philadelphia Federal Index survey surged in July. The Philly Fed Survey is a regional index published by the Philadelphia Federal Reserve that measures the changes in business growth. It showed that the manufacturing industry is on solid footing.
- Unemployment percentage remains low.
- Broad stock markets are holding at or near all-time highs.
Simply put, a Fed rate cut to boost an already growing economy doesn’t make sense.
The Fed wants to have these rate cuts available to support actual weak economic activity.
If the Fed lowers interest rates on a healthy economy, it will have fewer measures to take to support a widespread economic weakness.
Due to the stronger economy, we know that any rate cuts at this point are purely from pressure by investors. And this will set a precedent of investors pressuring the Fed to get what they want.
As I mentioned earlier, the Fed has two core mandates — full employment and stable prices. That’s it.
Unemployment is at historic lows, so it isn’t a concern.
It measures prices with inflation, which has stubbornly remained below its target.
But the Fed raised rates last year with inflation around the same level, so there is no reason to cut rates this month.
Except to please the market.
If the Fed gives in to the market’s pressure, it would raise a lot of concern from members of Congress.
I don’t think the Fed wants that kind of attention. So, it will hold off on a rate cut until the economy shows greater weakness.
I may be alone in this thinking, but I believe it’s important to prepare for what could be a very sharp market sell-off.
Which is why I have a way for you to hedge your portfolio today.
A Put Option to Protect Your Portfolio
Everybody is waiting for next week. The Federal Reserve will hold a two-day meeting. It’ll conclude on July 31.
We’ll know at 2 p.m. that day whether the Fed delivered on the market’s assumptions of a rate cut.
According to the widely followed CME FedWatch Tool, traders are expecting lower rates, and they want to see two more by early next year.
If the Fed fails to deliver on these assumptions, it means the stock market must adjust.
Right now, the market’s pricing in rate cuts from the Fed. This gives the market an added boost.
Without a rate cut in July, a market sell-off is certain.
The uncertainty of whether or not the Fed will cut rates is a major risk.
The Fed may follow through to please the markets. But I believe it’s best to take precautions for your portfolio.
The easiest way to do this is by buying a put option on the S&P 500 Index.
This puts you in a position to profit as the stock market dips if the Fed doesn’t lower interest rates on July 31.
You want to add this put option now. As we get closer to the actual date, volatility will pick up, and it will make it difficult to find the right option.
We’ll buy a put option on the exchange-traded fund (ETF) that tracks the S&P 500: SPDR S&P 500 ETF (NYSE: SPY).
You can grab the October 18, 2019 $298 put option this morning for around $8 a share, or $800 a contract.
Remember, this is to protect your portfolio from a major event by the Fed next week. If the market takes a sharp drop, this put option will rise in value.
A 5% dip in the markets could send this option up by 50% or more.
And if the Fed cuts rates and the market rises, the rest of your portfolio will continue to climb. In that case, you can exit your hedge with a modest loss.
Whether the Fed cuts rates or not next week, this may be one of those times where it can pay to go against the crowd.
Chad Shoop, CMT
Editor, Automatic Profits Alert
P.S. Last week, I mentioned that the Fed not cutting rates would be great news for the market — and it still holds true. Today, we are preparing for a short-term dip. And next week, I’ll elaborate on why the Fed not cutting rates would be the best scenario for stocks.