(Nov 19): Investors are hedging against the Federal Reserve (Fed) lowering borrowing costs next month, even as the odds of another interest-rate cut have come down to a coin flip.
Traders are looking to cash-in on the potential of a quarter-point rate cut by piling into December options linked to the secured overnight financing rate (SOFR), which closely tracks the federal funds rate. The bets come as a deluge of economic data starts to trickle in after the government’s longest shutdown in history.
Some central bank officials have recently expressed doubt about the need for another reduction this year after cutting rates in September and October. Fresh labour and inflation readings could make the case for more monetary easing.
Open interest, or the amount of new positions held by traders, continued to rise Monday in options that expire two days after the Fed’s rate announcement on Dec 10, making the trades an ideal hedge for policy decisions. The most active December SOFR option in recent weeks is the 96.50 strike, where around 863,000 of open interest currently lies. The level equates to a yield of 3.5%, or 38 basis points below the current fed effective rate.
The wave of wagers contrasts with current pricing in the interest-rate swaps market of about a 50-50 chance of a rate reduction at the Fed’s next meeting. That’s down from about a 70% of a quarter-point rate cut priced just two weeks ago. The recent shift in pricing has also filtered into next year, with less than a full quarter-point move now priced into the Jan. 28 decision.
See also: Foreign holdings of US Treasuries near record high in September
Treasury yields remain confined to a narrow band along the longer end of the curve amid a lack of fresh economic data for investors to assess the economy’s health. The void has kept 10-year yields to just an 11-basis-point span since the Oct 29 Fed meeting.
“The rates market continues to be range-bound, lacking a clear directional trend or significant structural shifts in positioning,” Citi strategist David Bieber said in a note.
This week’s JPMorgan Treasury client survey showed investors trimming outright long positions by a couple of percentage points, while short positions remained unchanged on the week.
See also: Fed’s Waller backs another cut as job market nears ‘stall speed’
A potential break out in yields may not be far away however, as the markets brace for the return of key government data starting Thursday, with the delayed release of the September nonfarm payrolls report.
Here’s a rundown of the latest positioning indicators across the rates market:
JPMorgan survey
For the week ended Nov 17, investors trimmed outright long positions by two percentage points, shifting to neutral with outright short positions unchanged over the week.
SOFR options flows
In SOFR options out to the Jun26 tenor, the past week has seen renewed interest in upside structures targeting the Fed to cut rates at the upcoming December policy meeting. This has been reflected by open interest rising across multiple Dec25 call strikes. Flows have included buying in the SFRZ5 96.1875/96.25/96.3125/96.375 call condors, SFRZ5 96.3125/96.375 1x2 call spreads and SFRZ5 96.3125/96.4375 call spreads.
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In SOFR options across Dec25, Mar26 and Jun26 tenors, the 96.50 strike remains the most populated, largely due to heavy exposure in the Dec25 calls. Outstanding risk around the strike includes SFRZ5 96.50/96.625 call spreads and SFRZ5 96.375/96.50 1x2 call spreads along with the SFRZ5 96.4375/96.50/96.5625 call flies. The SFRH6 96.50/96.75 call spreads have also been bought over the past week.
Treasury options premium
The premium paid on options to hedge Treasuries over the past week has edged back to neutral from favouring calls in the long-bond contracts. Premium in the front and intermediates of the futures strip remains to favour calls over puts, indicating traders paying more to hedge a Treasuries rally in the front-end and belly of the curve vs a selloff.
Uploaded by Isabelle Francis
