Bearish bet in utilities as interest rates rise

Utility stocks have enjoyed a short-term rally, but some traders seem to be bracing for a drop as interest rate headwinds emerge.

The Utilities Select Sector Index has gained 4.7 percent since mid-February, more than twice the return of the broader S&P 500. It’s underperformed over longer time frames as economic optimism lifts interest rates. That, in turn, can reduce the appeal of a sector typically valued for its dividend income.

This scenario may be coming in to play this week, as Federal Reserve officials spoke in favor of raising their target rate at the central bank’s next meeting on March 14 and 15. Even Lael Brainard, who forcefully opposed such moves last year, told a Harvard University audience that better employment and rising inflation now justify tighter monetary policy.1

A large transaction was detected in the index-tracking Utilities Select Sector SPDR Fund (NYSE ARCA: XLU) yesterday, with a block of 10,000 April 49 puts (options to sell a security) bought for $0.40. An equal number of April 46 puts sold for $0.11. 

This trade is called a vertical spread, and uses income from the lower-strike contracts to reduce the cost of the puts closer to the money. That creates the potential for greater leverage on a percentage basis. In this case, the net debit of $0.29 will inflate to $3 if XLU closes at $46 or lower on expiration. The fund closed at $51.68, so that could produce a return of more than 900 percent from the underlying security falling 11 percent. The position will expire worthless if no decline occurs.

Other events have the potential to move XLU. Four more Fed officials, including Chair Yellen, speak today, while next week brings key employment data from ADP and the Labor Department. 

Gold companies, which often follow utilities because interest rates can affect bullion prices, also saw bearish activity on Thursday. In Newmont Mining (NYSE: NEM), for instance, a block of 10,000 March 35.50 puts was sold for $2.32 and an equal number of March 33s were bought for $0.76. That was likely the work of a trader who took profits on a successful downside bet and then positioned for further declines. Colorado-based NEM, the world’s No. 2 gold producer, slid 2.38 percent to $33.60 in yesterday’s trading.

Gold Fields (NYSE: GFI), a smaller operator in South Africa, also saw 3,000 March 3 puts bought for $0.09. GFI ended the session down 3.79 percent to $3.05. It’s noteworthy that the NEM and GFI contracts expire on March 17, after the Fed meeting, so they’ll provide exposure to the event.

In addition to the catalysts cited above, this week has brought better-than-expected consumer confidence, manufacturing data and jobless claims. All of these positive numbers are typically viewed as consistent with higher interest rates.

In summary: traders are looking for weakness in companies with interest-rate risk as central bankers and the forward calendar hint that borrowing costs will continue to rise. 

1. Marketwatch: Fed's Brainard says economy can handle an interest-rate hike 'soon' 3/1/17