(Bloomberg) -- Stock market investors are playing defense ahead of this week’s highly anticipated Federal Reserve meeting following a shift toward traditionally safer sectors, even as sentiment edges toward a larger interest-rate cut by the central bank.
The S&P 500 Index’s options skew — which gauges how expensive it is to protect equity portfolios — is still above the level from before the early-August swoon, even with equities a whisker away from all-time highs. That’s because traders are hedging for downside risks. While the Fed is widely expected to cut interest rates on Wednesday for the first time since the depths of the pandemic, the question is how much.
After worries about a slowing economy sparked a rout in global markets in early August, traders have increased their positioning to above average levels in defensive corners of the market including utilities, consumer staples and real estate, according to data compiled by Deutsche Bank AG. Meanwhile, exposure in technology has declined significantly from above the historical range in July to now just modestly above average.
“Investors were getting more defensive heading into seasonally weak September and October and derisking ahead of the US election,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group. “But if the AI train gets moving again, investors might be forced back into tech stocks even before the election since we usually see equity strength into year-end.”
Last week, broad hedging was seen in the options market, with strategists pointing out buying of near-term put spreads in the S&P 500 and an associated exchange-traded fund that would protect againt a pullback in the benchmark index.
Subscribe to the Bloomberg Daybreak Asia podcast on Apple, Spotify or anywhere you listen.
But how much policymakers will reduce borrowing costs in the coming months remains a toss-up, with swaps markets Friday pricing in a roughly 40% chance of a half-point cut, up from almost no chance earlier in the week.
In the fed funds futures market linked to this week’s policy announcement, activity picked up sharply Thursday following a Wall Street Journal report suggesting a 50 basis point cut remained under consideration. Changes in open interest signaled traders covering short positions in October contracts, unwinding wagers targeting just a quarter-point move. Friday’s activity was mixed as traders grappled with the correct market policy pricing leading into Wednesday’s announcement.
That uncertainty is why the options market is betting the S&P 500 will swing 1.2% in either direction after the Fed’s decision on Wednesday, based on the price of that day’s at-the-money straddles, according to Citigroup Inc. That’s the highest implied move since the central bank’s gathering in March 2023, when Wall Street was in the midst of a regional bank crisis.
Looking further out, in the options market linked to the secured overnight financing rate, recent flows have been skewed toward upside protection and adjusting dovish hedges — not just around the September policy but also further out to the end of the year as the swaps market still prices in at least one half-point cut by the December meeting of the Federal Open Market Committee.
The overall duration picture remains bullish in Treasuries, with any weakness appearing to warrant a green light to buy the dip. Last week, futures open interest across all tenors on the curve jumped after the inflation report, a sign that investors favored initiating new long positions at lower price levels.
Currency trading is reflecting the diverging monetary-policy outlooks between the US and Japan as the two countries’ central banks meet. The yen has rallied approximately 3.7% in September through Friday, compared with a 0.7% decline in the dollar.
Still, options markets are positioning for further dollar-yen declines in the coming week and month, based on pricing of risk reversals. Traders expect the dollar to break below 140 yen — a key support level in place for more than a year — as rate decisions from the Fed and Bank of Japan loom.
Gold traders are betting record-high prices will go even higher with rates heading lower, with some taking insurance against the possibility of a larger cut. Open interest in the $3,400 strike grew the most of any October option over the past week, according to CME Group Inc. data.
--With assistance from Edward Bolingbroke, George Lei and Yvonne Yue Li.
©2024 Bloomberg L.P.
