Over-the-Top Optimism on XLF Ahead of the Fed

When the Federal Open Market Committee (FOMC) announces its latest policy ruling this Wednesday afternoon, Wall Street is pricing in a roughly 100% chance of a rate hike (per CME Group's FedWatch Tool). And likewise, bank stock bulls appear to have priced in plenty of enthusiasm over this widely anticipated tightening move, judging by recent option activity on the Financial Select Sector SPDR Fund (XLF).

Consider, for example, the current total XLF call open interest accumulation of 2.54 million contracts, which Trade-Alert places in the 97th percentile of its annual range. And then consider that a very respectable 222,102 of those calls lie directly overhead, at the weekly 12/29 28-strike call... and that nearly 85% of those weekly calls were added within the past five trading days, and that the action was largely buyer-driven. And now you're starting to get an idea of the excitement surrounding the finance sector these days.

In fairness, XLF traders are keying not just on the upcoming Fed rate hike we're likely to get this week, but also the hopes of corporate-friendly tax reform from Capitol Hill. Yes, that Capitol Hill -- home to a group of lawmakers who managed, late last week, the bipartisan feat of delaying a government shutdown by all of two weeks. Are XLF bulls anticipating that this Congress will deliver enough of a legislative "win" to supply fresh fuel for a stock market that's been running on the same "pro-business" enthusiasm for over a year now?

Meanwhile, on the charts, XLF $28 is not only the home of massive short-term call open interest (which we've often observed can act as a structural obstacle in the weeks leading up to expiration, due to the hedging mechanism), but it's also the site of some historically significant round-number percentage returns. The $28 region is about 10% below the fund's 2007 all-time high, 400% north of the March 2009 monthly closing low, 40% above the pre-election close of $19.99 on Nov. 8, 2016, 20% above the 2016 year-end close, and 10% higher than XLF's early August/mid-September highs.

Worth noting, finally, is that on a historical basis, XLF has averaged a modest gain of less than 1% in the month of December. A similar performance in 2017 would place the shares no higher than $27.79 by the time those weekly 12/29 calls are expiring (the fund settled Friday exactly at $28.00, by the way).

In other words, a push above XLF $28 by year-end would be a strongly bullish development for the financial sector -- but a period of hesitation, churning, and consolidation might be more predictable, and a short-term drawdown entirely possible.