The Fed's big event is approaching, the options market is heating up with "bets"

Ahead of the highly anticipated Federal Reserve meeting this week, stock market investors are taking defensive measures, turning to traditionally safer sectors despite market sentiment leaning towards a larger Fed rate cut.

The skew of S&P 500 index options (measuring the cost of protecting stock portfolios) remains higher than pre-August levels before the sharp drop, even though the index is just a step away from its historical high. This is because traders are hedging downside risks. While it is widely expected that the Fed will cut rates for the first time since the pandemic this week, the question remains on the magnitude of the rate cut.

According to data compiled by Deutsche Bank AG, following concerns about economic slowdown triggering a global market plunge in early August, traders have increased positions in defensive stocks such as utilities, basic consumer goods, and real estate to above-average levels. At the same time, exposure to tech stocks has significantly decreased from record levels in July, currently only slightly above average.

Traders' exposure changes across sectors

Chris Murphy, Co-Head of Derivatives Strategy at Susquehanna International Group, stated, "Investors are becoming more defensive as they enter the seasonally weak months of September and October, reducing risk exposure ahead of the U.S. election. However, if the AI frenzy revives, investors may even be forced back into tech stocks before the election, as we typically see a strong market performance towards the end of the year."

Last week, there was widespread hedging activity in the options market, with strategists recommending buying short-term bearish option spreads on the S&P 500 index and related exchange-traded funds (ETFs) to guard against a pullback in the index.

The suspense remains on how much rate cuts policymakers will make in the coming months, with the futures market pricing in a 40% chance of a 50 basis point rate cut this week, significantly higher than earlier expectations.

In the federal funds rate futures market linked to the Fed policy meeting, market activity surged last Thursday after a report by The Wall Street Journal hinted at the Fed considering a 50 basis point rate cut. Changes in open interest contracts indicate traders covering short positions in October contracts, essentially closing out bets on a 25 basis point rate cut by the Fed this week.

Citigroup noted that this uncertainty is why the options market is betting on the S&P 500 index swinging in either direction by 1.2% after the Fed makes its rate decision on Wednesday in U.S. Eastern Time, with this expected volatility based on the price of straddle options that day. This is the highest implied volatility since the regional banking crisis in March 2023.

Straddle option prices indicate the S&P 500 index is expected to fluctuate up and down by 1.2% after the Fed makes its rate decision on Wednesday in U.S. Eastern Time Taking a longer-term view, in the options market linked to the Secured Overnight Financing Rate (SOFR), recent fund flows tend to favor upward protection and adjustment of dovish hedges. This is not only due to uncertainty surrounding the magnitude of rate cuts in September, but also because the swap market still reflects at least one 50 basis point rate cut by the Federal Reserve before the end of this year.

US Treasuries overall still appear bullish, with any weakness seemingly prompting buying on dips. Last week, after the inflation report was released, open interest in US Treasury futures contracts across all maturities surged, indicating investors are inclined to establish new long positions at relatively lower price levels.

As the central banks of the US and Japan hold meetings, forex trading reflects divergence in the monetary policy outlook of the two countries. As of last Friday, the Japanese yen has appreciated by about 3.7% in September, while the US dollar has declined by 0.7% during the same period.

Based on pricing for risk reversals, the options market is preparing for further declines in the USD/JPY over the next week and month. Traders anticipate that as the Federal Reserve and the Bank of Japan are set to make interest rate decisions, the USD/JPY will break below 140, which is a key support level for the currency pair over the past year.

Gold traders, on the other hand, are betting that record prices will continue to rise as interest rates fall, with some traders taking precautions against the possibility of larger rate cuts. Data from the Chicago Mercantile Exchange (CME) shows that in the past week, open interest in options expiring in October with a strike price of $3400 saw the largest increase among all contracts.