Guessing game on Fed upping rates to stoke market volatility
Guessing game over whenFed will increase US borrowing costs prompts investors to place bearish contracts on banks, brokerages and insurers
The guessing game over when the United States Federal Reserve will raise interest rates is underpinning bets for more volatility across shares of banks, brokerages and insurers.
Traders are buying up options that pay off if the industry slumps and now own 2.2 puts for each call on the Financial Select Sector SPDR Fund, the most in almost a year.
The cost of one-month bearish contracts is above the five-year average relative to bullish ones and puts make up nine of the top 10 options with the highest ownership.
With so much uncertainty around interest rates, financials could be affected in a big way
Investors are parsing economic data for signs of inflation and improvement in the labour market that may lead the central bank to increase borrowing costs sooner.
In June, policymakers forecast they would raise the federal funds rate above zero next year, without specifying a month.
While higher interest rates may increase bank profit margins on loans and returns from new investments, it can also hurt earnings if borrowing costs rise before the loan yields increase.
"People who own financials are getting nervous," said Joe Kinahan, the chief strategist at online broker TD Ameritrade Holding. "With so much uncertainty around interest rates, financials could be affected in a big way. If we're in this limbo land for a while, some of those stocks will suffer."
The first rise in the federal funds rate will probably be in the third quarter of next year, according to a survey of economists.
Vague forecasts from central bank leaders and mixed economic data have made it difficult for investors to gauge when rates will rise.
Last month, the Federal Open Market Committee repeated that the central bank was likely to keep interest rates low for a "considerable time" after ending bond purchases.
Fed chairman Janet Yellen reminded investors in her testimony to Congress last month that if labour markets improve more rapidly than the committee expects, increases in the federal funds rate would probably occur "sooner and be more rapid than currently envisioned".
While her view of the economy has turned "more positive", she is concerned about low participation in the labour force and sluggish wage growth.
At the same time, US gross domestic product expanded 4 per cent in the past quarter amid a rebound in consumer spending and business investment.
When the report was published on July 30, traders exchanged the most bearish contracts on the XLF fund in more than seven years relative to bullish ones.
Options protecting against a 10 per cent drop in the fund cost 10.4 points more than calls betting on a 10 per cent rise. That is above the 9.3 point average for the price relationship known as skew since 2009.
Puts with a strike price of US$21 and US$19 that expire at the end of the week have the highest ownership.
"There's just tonnes of bearish activity," said Mark Sebastian, the founder of Option Pit, an education and consulting firm.
The conflict between Ukraine and Russia, Israel's strikes against Gaza and concern the turmoil is hurting the European economy has increased the turbulence across global equity markets.
The Chicago Board Options Exchange Volatility Index has jumped 38 per cent since reaching a seven-year low on July 3.
About US$230 million was pulled from the XLF last week, the fund's seventh week of withdrawals out of eight.
The ETF, which counts Wells Fargo, Berkshire Hathaway and JP Morgan Chase among its largest holdings, is up 50 per cent in the past two years. The Standard & Poor's 500 Index has rallied 38 per cent since then.
"The more volatility you get in the market, the more people are going to take money out of the financials," said Matt McCormick, a vice-president and portfolio manager at Bahl & Gaynor. "They've had a good run. For the most part, the news has looked OK, but the news going forward looks choppy."
