Stock market investors are taking a defensive stance ahead of this week's much-anticipated Federal Reserve meeting after moving into traditionally safer sectors even as sentiment favors bigger rate cuts from the Fed.

The skewness of S&P 500 options, a measure of the cost of protecting a stock portfolio, remains higher than before the early August rout, even as the index is within striking distance of its all-time high. That’s because traders are hedging downside risk. While the Federal Reserve is widely expected to cut interest rates this week for the first time since the pandemic, the question is how much.

After concerns about an economic slowdown sparked a global market rout in early August, traders increased their positions in defensive stocks such as utilities, consumer staples and real estate to above-average levels, according to data compiled by Deutsche Bank AG. Meanwhile, exposure to technology stocks has fallen sharply from record levels in July and is now just above average.

Changes in traders’ exposure to various sectors

Chris Murphy, co-head of derivatives strategy at Susquehanna International Group, said: "Investors are becoming more defensive as they head into the seasonally weak September and October and are reducing risk exposure ahead of the U.S. election. But if the AI ​​boom picks up again, investors may be forced back into tech stocks even before the election, as we typically see stocks strengthen toward the end of the year."

Broad hedging activity emerged in options markets last week, with strategists recommending buying short-dated put spreads on the S&P 500 and related exchange-traded funds to help protect against a pullback in the index.

How much policymakers will cut rates in the coming months remains an open question, with swaps markets pricing in about a 40 percent chance of a 50 basis point cut this week, much higher than earlier expectations.

In the federal funds futures market, which is tied to the Fed’s policy meetings, activity picked up sharply on Thursday after a Wall Street Journal report suggested the central bank was still considering a 50 basis point rate cut. Changes in open interest showed traders covering short positions in October contracts, or unwinding bets that the Fed would cut rates by 25 basis points this week.

That uncertainty is why options markets are betting the S&P 500 will move 1.2% in either direction after the Fed’s rate decision on Wednesday, Citigroup said, based on the price of at-the-money straddles that day. That’s the highest implied volatility since the Fed’s March 2023 policy meeting, when Wall Street was in the midst of a regional banking crisis.

At-the-money straddle options prices indicate that the S&P 500 will fluctuate 1.2% after the Federal Reserve makes its interest rate decision on Wednesday, Eastern Time.

Looking further out, in options markets tied to the secured overnight financing rate (SOFR), recent flows have favored upside protection and dovish hedging, not only because of uncertainty surrounding the magnitude of the September rate cut, but also because swap markets still reflect at least one 50 basis point rate cut by the Fed before the end of the year.

Treasuries remain bullish overall and any weakness seems to be a green light for buying on dips. Last week, open interest in Treasury futures of all maturities jumped after the inflation report was released, suggesting that investors prefer to initiate new long positions at lower price levels.

As the U.S. and Japanese central banks meet, foreign exchange trading reflects the divergence in the outlook for monetary policy in both countries. As of last Friday, the yen had appreciated by about 3.7% in September, while the dollar fell 0.7% over the same period.

The options market is preparing for further declines in the dollar against the yen over the coming week and month based on pricing in risk reversals. Traders expect the dollar to fall below 140 yen, a key support level for the currency pair for more than a year, as the Federal Reserve and the Bank of Japan make upcoming interest rate decisions.

Traders further bullish on yen ahead of Bank of Japan rate decision

Gold traders are betting that record prices will rise further as interest rates move lower, with some taking precautions against the possibility of a bigger rate cut. Open interest in the $3,400 strike price saw the biggest increase of all October expiration options over the past week, according to CME Group data.

The article is forwarded from: Jinshi Data