After the Federal Reserve decided to maintain its current interest rate, a wave of aggressive bets on a July rate hike was rapidly reversed, leading to a mass unwinding of large short positions built around the August federal funds futures contract.
Market data reveals that the closely watched open interest for the August federal funds futures contract briefly surpassed 1 million contracts for the first time ever before the Fed's policy meeting, representing a notional value of approximately $5 trillion. This highlighted the deep division among investors over the rate outlook ahead of the July policy session. It was also the second monetary policy meeting chaired by the newly appointed Fed Chair, Kevin Warsh.
David Robin, Managing Director and interest rate strategist at TJM LLC, noted that market participants broadly anticipated the Fed would need to raise rates to preserve policy credibility, prompting them to build substantial positions betting on a hike. However, Warsh's previous public statements had effectively signaled that "July was not the time for action," including his repeated emphasis on the need for more economic data to guide decisions. As a result, the market's heavy bets on a July rate hike ultimately proved to be misdirected.
Robin added that within less than five seconds of the Fed's announcement to hold the federal funds rate at its 3.5% to 3.75% target range, the August federal funds futures price had already fully adjusted, causing significant losses on the large short positions betting on a rate hike.
Data from the Chicago Mercantile Exchange on Thursday showed that open interest for the August federal funds futures contract fell by approximately 140,000 contracts from the previous trading day, indicating that a substantial number of short positions had been closed out or stopped out. Because the August contract expires before the next Fed meeting on September 16th, shorting this contract effectively meant betting on a rate hike at the July meeting.
Just before the rate decision was announced, the interest rate swap market had priced in roughly a one-in-three chance of a July hike, with the implied rate hike expectation reaching as high as 12.5 basis points, nearly a coin-flip probability. However, after the Fed held steady, the implied rate hike expectation quickly fell to about 7 basis points, driving a sharp rally in the August federal funds futures price and swiftly turning previously profitable short positions into losses.
Data from the Commodity Futures Trading Commission shows that since May, leveraged funds had been steadily increasing their short positions in federal funds futures, reaching their highest level in about a year. Meanwhile, market makers were consistently building long positions on the other side of these leveraged fund trades.
The most notable trade in the market occurred on June 16th, the day before Warsh's first policy meeting as chair. On that day, a massive block sell order of 50,000 August federal funds futures contracts was executed at a price of 96.350, with each basis point move representing a profit or loss of about $2.1 million. If that position was held until this week's meeting, it had briefly shown an unrealized profit of around $10 million before the policy announcement. However, following the Fed's decision to hold rates steady, the position had swung to a loss of roughly $3 million by Wednesday's close.
Additionally, ahead of the Wednesday meeting, the market saw short trades of about 20,000 August federal funds futures contracts executed at prices between 96.295 and 96.290. If these positions were not closed in time, the day's losses amounted to approximately $6 million. Due to the anonymous nature of futures market trading, it is impossible to confirm the specific institutions involved or the ultimate beneficiaries of these trades.
Although the volume for the August federal funds futures contract remained relatively high at about 215,000 contracts on Thursday, it was significantly lower than the record 728,000 contracts traded on Wednesday, when a concentrated wave of position unwinding drove volume sharply higher. In comparison, the average daily volume for this contract over the previous 15 trading sessions was around 318,000 contracts.
Alan Taylor, Founding Partner at Archr LLP, commented that when the market initially priced in only about 3 basis points of a rate hike, establishing related hedge positions offered good value. However, as the market gradually pushed the rate hike expectation to around 9 basis points, the risk of holding those positions increased significantly.
Taylor noted that given the sheer size of the positions, it was a reasonable choice to build protective hedges early when hedging costs were low. However, as rate hike expectations continued to rise, some investors began to reduce their positions, as the market never fully believed that the probability of a July rate hike would exceed 50%.
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