Guessing Game on Rates Lifts Bearish Bets on Financials: Options

Aug 12, 2014 8:20 am ET

(For an Options column news alert: SALT OMA.)

Aug. 12 (Bloomberg) -- The guessing game over when the 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, data compiled by Bloomberg show.

Investors are parsing economic data for signs of inflation and improvement in the labor market that may lead the Federal Reserve to increase borrowing costs sooner. In June, policy makers forecast they would raise the Fed funds rate above zero sometime 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,” Joe “JJ” Kinahan, chief strategist at TD Ameritrade Holding Corp., said in a phone interview. The Omaha, Nebraska-based firm manages about $650 billion in client assets. “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.”

Fed Funds

The first increase in the Fed funds rate will probably be in the third quarter of next year, according to the median economist forecast from a Bloomberg survey.

Vague forecasts from central bank leaders and mixed economic data has made it difficult for investors to gauge when rates will rise. In July, the Federal Open Market Committee repeated that the central bank is likely to keep interest rates low for a “considerable time” after ending bond purchases.

Fed Chair Janet Yellen reminded investors in her testimony to Congress last month that if labor 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’s concerned about low participation in the labor force and sluggish wage growth.

Bearish Contracts

At the same time, U.S. gross domestic product expanded 4 percent last 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, according to data compiled by Bloomberg.

Options protecting against a 10 percent drop in the fund cost 10.4 points more than calls betting on a 10 percent rise, according to one-month data compiled by Bloomberg. That’s above the 9.3-point average for the price relationship known as skew since 2009.

Puts with a strike price of $21 and $19 that expire at the end of the week have the highest ownership. The exchange-traded fund rose 0.1 percent to $22.40 yesterday.

“There’s just tons of bearish activity,” Mark Sebastian, founder of Option Pit LLC, a Chicago-based education and consulting firm, said by phone. “There’s a lot of things up in the air between now and the October, November time frame for these stocks.”

Market Turbulence

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 percent since reaching a seven-year low on July 3.

Bigger price swings may lead to higher trading volumes and support profits for banks and brokerages, according to Julian Emanuel, a U.S. equity and derivatives strategist with UBS Securities LLC in New York. An average of 6.1 billion shares have changed hands on U.S. exchanges this month, compared with 5.7 billion in July, data compiled by Bloomberg show.

“We are buyers of large-cap financials on further weakness as this group will benefit from more volatility,” Emanuel said in an Aug. 4 note.

Low interest rates have crimped banks’ profitability. Net interest margin, the difference between what a firm pays in deposits and charges for loans, was a record-low 3.1 percent last quarter, according to St. Louis Fed data on U.S. banks with average assets greater than $1 billion.

Getting Out

Other investors are less bullish. About $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 & Co., Berkshire Hathaway Inc. and JPMorgan Chase & Co. among its largest holdings, is up 50 percent in the past two years. The Standard & Poor’s 500 Index has rallied 38 percent since then.

“The more volatility you get in the market, the more people are going to take money out of the financials,” Matt McCormick, a Cincinnati-based vice president and portfolio manager at Bahl & Gaynor Inc., which manages about $12 billion, said by phone. “They’ve had a good run. For the most part, the news has looked OK, but the news going forward looks choppy.”

--With assistance from Elizabeth Dexheimer in New York.