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 If the Fed lays out an aggressive schedule of future rate increases,
stock markets could become very volatile and even plummet, say
strategists who expect a market-calming central bank announcement
detailing the patience of policymakers.
Activity in the options market suggests stock traders are being
cautious ahead of the Fed policy meeting on Dec. 15-16, and options
expiry at the end of next week could amplify volatility in either
direction.
"If...(policymakers) came out saying that over the next two years
they will raise by 'this' much, that would be very destabilizing,"
said Brian Battle, director of trading at Performance Trust Capital
Partners in Chicago.
"The market will take great relief in the Fed communicating it will
be very patient for the next increase."
Even so, traders hoping to profit on the Fed's expected statement
lack a playbook. The markets haven't been through the current
scenario of a rate lift-off after years in which the central bank's
short-term interest rates have been locked near zero.
That could partly explain the jittery trading on Wall Street this
week, during which volatility has risen and the benchmark S&P 500
dropped 3.5 percent.
A slew of economic data due to be released before the Fed meeting,
including readings on growth in manufacturing, industrial production
and consumer prices, could cause some choppiness if traders take any
robust data as a sign that the Fed may be more aggressive with
future rate increases.
Furthermore, markets could face an interruption next week if
Congress and President Barack Obama trigger a government shutdown by
failing to finish work on a $1.5 trillion government funding bill.
OPTIONS POSITIONING
That uncertainty has helped trigger bets in the options market by
investors trying to cover themselves against a wide array of
outcomes in stocks, and similar uncertainty has been apparent across
other asset classes as well.
Crude oil futures fell to seven-year lows while the euro, expected
to decline against the dollar as the Fed tightens, rallied after
many covered those bets.
As expected, exchange-traded funds and individual stocks in
rate-sensitive sectors such as financial firms and real estate
investment trusts have attracted a lot of options trading activity
betting on sharp moves - in both directions - in the wake of a Fed
announcement.
"We are seeing a lot of heavy positioning" in front of the Fed, said
Steven Sosnick, equity risk manager for Timber Hill, the
market-making division of Interactive Brokers.
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That positioning is leaning more heavily toward seeking protection
against a broad stock market move lower, said traders who expect
volatility to spike after the Fed meeting.
S&P 500 <.SPX> options expiring next Friday imply a 2.9 percent move
in the index by the end of the week.
The CBOE Volatility Index <.VIX>, the market’s favored barometer of
trader angst, has crept over its long-term average of 20, after
having stayed mostly below that level since early October. On
Friday, it was up 28 percent at 24.72.
That level is higher than futures show the VIX going forward,
signifying that traders are more worried about near-term volatility
than they are about a long-term breakdown.
But a sharp move to the downside could be amplified since the Fed
decision comes just two days ahead of "quadruple-witching," when
options on stocks and indexes and futures on indexes and
single-stocks all expire, making the index particularly prone to a
jump in volatility.
JPMorgan derivatives analysts estimate that nearly $1.1 trillion of
S&P 500 options are set to expire on Friday morning, about 60
percent in put options, typically used as portfolio hedges.
In case of an adverse reaction in stocks, the accumulation of large
blocks of open SPX put contracts at the 2,000, 1,950, and 1,900
levels, could force more selling. Market makers who have sold those
contracts would be forced to sell equities to reduce their risk.
This kind of activity was one of the key reasons for the market
selloff in late August, when the S&P entered its first correction in
more than four years.
(Editing by Linda Stern and Bernadette Baum)
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