Bond traders are establishing significant positions, betting on multiple interest rate hikes from the Federal Reserve in the coming months, with some anticipating action as early as the September policy meeting.
This is the prevailing theme in the options market linked to the Secured Overnight Financing Rate (SOFR), which is sensitive to Federal Reserve policy. Since last Friday's unexpectedly robust U.S. jobs report triggered a selloff in bonds, traders have been increasing their wagers on rate increases.
A surge in trading activity occurred on Friday, with several transactions structured to profit if the Fed hikes at least once this year. The volume of options traded was roughly double the typical level. Although spot markets recovered somewhat on Tuesday amid falling oil prices and equities, related trading activity continued. One notable trade is positioned to benefit from at least one, and possibly two, rate increases by the time of the mid-September meeting.
This rapid market shift towards hedging against hawkish risks followed the May U.S. employment report, where job growth exceeded all forecasts, offering the clearest sign yet that the labor market may be emerging from a prolonged hiring slump. Attention now turns to a crucial inflation report due Wednesday, which is anticipated to show persistent price pressures.
"The combination of a strong non-farm payrolls number and uncomfortably high inflation is increasing the probability that the market is assigning to the Fed having to tighten," said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities. "That continues to keep yields elevated, although the risk-off move in equities seems to be helping to support yields."
The bearish sentiment in the options market is mirrored in futures markets, where pricing now fully reflects expectations for a 25-basis-point Fed rate hike by year-end. The latest data from the Commodity Futures Trading Commission (CFTC) shows hedge funds increased their net short positions in SOFR futures to a record high just before the jobs report release.
"Short momentum remains dominant," wrote Citigroup strategist David Bieber in a note on Tuesday.
Of course, these leveraged short positions could also be associated with various strategies, such as basis trades relative to spot or swaps, convexity hedging, or simply directional bets.
The further accumulation of bearish bets in futures markets means SOFR futures are vulnerable to short-covering flows if conviction about rate hikes begins to waver. A weaker-than-expected May Consumer Price Index (CPI) report on Wednesday could temper this positioning, while a stronger-than-expected reading could act as a catalyst for more hawkish options flows.
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