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

$S&P 500 Index (.SPX.US)$ The skewness of options (which measures the cost of protecting a stock portfolio) is still higher than it was before the sharp drop in August, even though the index is just one step away from its historical high. This is because traders are hedging downside risks. While it is widely expected that the Federal Reserve will cut interest rates for the first time since the pandemic this week, the question is how much the rate cut will be.

According to data compiled by Deutsche Bank AG, after the global market plunged in early August due to concerns about economic slowdown, traders have increased their positions in defensive stocks such as utilities, basic consumer goods, and real estate above the average level. Meanwhile, exposure to technology stocks has significantly decreased from the record levels seen in July and is now only slightly above the average level.

Chris Murphy, co-head of derivative strategies at Susquehanna International Group, said, "Investors are becoming more defensive as we enter the seasonally weak months of September and October, and they are reducing their risk exposure ahead of the US election. However, if the AI boom resumes, investors may be forced to return to tech stocks even before the election, as we typically see the stock market strengthen before the end of the year."

Last week, there was widespread hedging activity in the options market. Strategists suggested buying put spreads on the S&P 500 index and related ETFs to hedge against a potential pullback in the index.

It is still a mystery how much the policymakers will cut interest rates in the coming months. The pricing in the forward market last Friday indicated a 40% probability of a 50 basis points rate cut this week, much higher than earlier expectations.

In the federal funds rate futures market tied to the Federal Reserve policy meeting, market activity intensified last Thursday after an article in the Wall Street Journal suggested that the Fed is still considering a 50 basis points rate cut. The change in open interest contracts indicated traders covering short positions on the October contracts, which means closing bets on a 25 basis points rate cut by the Fed this week.

Citigroup stated that this uncertainty is the reason why the options market is betting that the S&P 500 index will fluctuate by 1.2% in either direction after the Fed's interest rate decision on Wednesday. This expected volatility is calculated based on the prices of at-the-money straddle combinations on that day. It is the highest implied volatility since the Fed policy meeting in March 2023, when Wall Street was in the midst of a regional banking crisis.

Looking at the longer term, in the options market tied to the Secured Overnight Financing Rate (SOFR), recent fund flows have been inclined towards upside protection and adjusting dovish hedges. This is not only due to uncertainty surrounding the extent of rate cuts in September, but also because the forward market still reflects at least one 50 basis points rate cut by the Fed before the end of this year.

US Treasury bonds are still bullish overall, with any weakness seen as a buying opportunity. Last week, after the inflation report was released, open interest contracts for US Treasury bond futures across all maturities surged, indicating investors' preference for establishing new long positions at lower price levels.

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

Based on the pricing of risk reversal, the options market is preparing for a further decline in the USD/JPY in the coming week and month. Traders expect the USD/JPY to break below 140 as the Federal Reserve and the Bank of Japan are about to make interest rate decisions, which is a key support level for the currency pair in over a year.

Gold traders are betting that record prices will continue to rise further as interest rates decline, and some traders are taking precautions against the possibility of larger rate cuts. Data from the Chicago Mercantile Exchange (CME) shows that open interest in options expiring in October with a strike price of $3400 has seen the largest increase in the past week.

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