Analysts at JPMorgan Chase say the Federal Reserve has 670 billion reasons to deliver a "dovish hike" if it elects next week to raise interest rates for the first time in nine and a half years.
The consensus view is that the central bank will take care to avoid upsetting risk appetite at the time of liftoff by emphasizing a gradual glide path higher for rates, lowering the "dot plot" of preferred policy rates, or inserting language that ties additional hikes to actual increases in inflation. A return to robust monthly jobs growth and nascent signs of accelerating wage increases have, however, left more than a few economists doubting that a hike will be accompanied by overtly dovish messaging.
A report from JPMorgan's global quantitative and derivatives team, led by Marko Kolanovic, emphasizes the necessity of not roiling the markets. Extenuating circumstances in the options market could provoke a wave of selling pressure in equities precisely when the Fed seeks to ease markets into a new rate regime, Kolanovic warned.
"This important event falls at a peculiar time–less than 48 hours before the largest option expiry in many years," wrote Kolanovic, noting that $1.1 trillion worth of Standard & Poor's 500-stock index options–of which $670 billion are puts–will expire on Dec. 18. Roughly one-third of the puts poised to expire are at or near the money, with strike prices from 1,900 to 2,050.
"Clients are net long these puts and will likely hold onto them through the event and until expiry," the strategist wrote. "At the time of the Fed announcement, these put options will essentially look like a massive stop loss order under the market."
When a put is close to expiry, the writer of the option becomes a seller of the underlying security as it hits the strike price in order to mitigate the exposure. Thus, a negative reaction in the S&P 500 index to the Fed decision could trigger a wave of forced selling, potentially agitating markets.
No one knows better than Kolanovic how systematic selling can amplify price changes in financial markets.
However, it's fair to quibble with the premise: Is Janet Yellen really monitoring open interest in options linked to the S&P 500?
On the other hand, August's carnage in financial markets did play a role in the Fed's decision to refrain from raising rates in September. As such, any trauma stemming from the end of the zero-interest-rate policy could affect the pace at which rates rise.
"Given the poor liquidity near the end of the year and peculiar option technicals, we think a likely and rational expectation is for a dovish message on the pace of rate hikes next Wednesday," concluded Kolanovic.