Traders Play Defense With a Fed Rate Cut on the Rise

Stock market investors are adopting a defensive approach as they await this week's crucial Federal Reserve meeting. Despite a growing expectation for a more significant interest rate cut by the central bank, there's a noticeable shift towards traditionally safer sectors. The S&P 500 Index's options skew, which measures the cost of protecting equity portfolios, remains elevated compared to levels before the market downturn in early August. This suggests that traders are actively hedging against potential downside risks, even as equities hover near their all-time highs. While the Fed is anticipated to lower interest rates on Wednesday, marking the first reduction since the pandemic's peak, the extent of the cut remains uncertain.

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In early August, concerns about a slowing global economy triggered a significant market sell-off. Since then, traders have increased their investments in defensive market sectors such as utilities, consumer staples, and real estate. According to data from Deutsche Bank AG, exposure to these areas has risen to above-average levels. Conversely, investment in the technology sector has declined sharply, falling from above its historical average in July to a more modest position now.

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"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. He added, "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."

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Last week, the options market saw widespread hedging activity. Strategists highlighted the purchase of near-term put spreads in the S&P 500 and related exchange-traded funds as investors sought protection against a potential pullback in the benchmark index.

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However, the degree to which the Federal Reserve will reduce borrowing costs in the coming months is still uncertain. On Friday, swap markets indicated about a 40% chance of a half-point rate cut, up from nearly zero earlier in the week. This uncertainty is reflected in the options market, which predicts the S&P 500 could swing 1.2% in either direction following the Fed's decision on Wednesday. According to Citigroup Inc., this expectation is based on the pricing of at-the-money straddles for that day and represents the highest implied move since the central bank's meeting in March 2023 when the market was dealing with a regional bank crisis.

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In the fed funds futures market, linked to this week’s policy announcement, there was a sharp increase in activity on Thursday. This surge followed a Wall Street Journal report suggesting that a 50-basis-point cut was still being considered. Changes in open interest revealed that traders were covering short positions in October contracts, reversing bets that had been placed on only a quarter-point move. Friday’s market activity was mixed as traders struggled to interpret the correct policy pricing ahead of Wednesday’s announcement.

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Looking further ahead, the options market tied to the secured overnight financing rate has recently seen a tilt towards upside protection and the adjustment of dovish hedges. This isn't limited to the September policy decision but extends to the end of the year, as the swaps market still anticipates at least one half-point cut by the December meeting of the Federal Open Market Committee.

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Overall, the duration outlook in the Treasury market remains bullish. Any weakness seems to present a buying opportunity. Last week, futures open interest across all maturities on the curve surged following the release of the inflation report. This jump indicates that investors were keen on initiating new long positions at lower price points.

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In the currency markets, trading patterns are mirroring the diverging monetary policy outlooks between the U.S. and Japan as both countries' central banks prepare to meet. The yen has rallied around 3.7% in September through Friday, in stark contrast to a 0.7% decline in the U.S. dollar.

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Despite this, options markets are bracing for further declines in the dollar-yen pair in the upcoming week and month, based on the pricing of risk reversals. Traders anticipate that the dollar will fall below the 140-yen mark—a crucial support level that has held for more than a year—as decisions from both the Federal Reserve and the Bank of Japan loom.

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In the commodities market, gold traders are betting on record-high prices moving even higher as interest rates decline. Some investors are seeking protection against the possibility of a more significant rate cut. Open interest in the $3,400 strike for October options has seen the most substantial growth over the past week, according to data from CME Group Inc.

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In summary, as the highly anticipated Federal Reserve meeting approaches, stock market investors are taking a more defensive stance. There's an increased focus on traditionally safer sectors like utilities, consumer staples, and real estate while reducing exposure to the technology sector. Options markets are signaling significant potential market swings following the Fed's decision. The broader uncertainty around how much policymakers will reduce borrowing costs and how that will affect various markets is keeping investors on edge. Whether the central bank opts for a quarter-point or a half-point cut will set the tone for the market’s direction in the coming months, influencing not just equities but also bonds, currencies, and commodities.

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