Hedging economic recession risks, the options market predicts a significant 300 basis point rate cut by the Federal Reserve within a year
To hedge against the risk of an economic recession, the options market predicts that the Federal Reserve will cut interest rates by 300 basis points within a year. Market participants expect the Fed to cut rates by about 75 basis points, but some investors are starting to increase their bets to hedge against the consequences of tail risks. Data from Morgan Stanley and Goldman Sachs also indicate a dovish stance in the spot market. Although this outcome is unlikely to occur unless the U.S. economy suddenly enters a recession, investors are still monitoring economic data and speeches by Fed officials to look for clues on the timeline for monetary policy easing
Zhitong Finance APP noticed that in the past three trading days, the positions in the options market related to overnight financing rates with guarantees showed that if the Federal Reserve lowers its key rate to a low of 2.25% in the first quarter of 2025, bets will increase.
Unless the U.S. economy suddenly falls into a recession, this outcome seems unlikely. This implies that the Federal Reserve will cut rates by at least 300 basis points from the current level. This type of bet can be used to hedge another investment.
Considering that market participants expect the Fed to cut rates by about 75 basis points during this period, this is a bold stance. Federal Reserve officials recently predicted that by the end of this year, they would only cut rates by 25 basis points, totaling 125 basis points by the end of 2025.
Investors have been carefully studying economic data and speeches by Federal Reserve officials to find clues to the exact timing of the Fed's eventual monetary policy easing. Now, some investors are also increasing their bets to hedge against the consequences of tail risks - such as rapid and extreme rate cuts. Many of these trades are anonymous, making it difficult to determine the companies behind these bets.
In the federal funds market, traders have been heavily buying August contracts, which will pay off if policymakers cut rates at the policy meeting on July 31. Meanwhile, swaps linked to the meeting date only reflect expectations of a one basis point rate cut at that time.
Data from Morgan Stanley shows that the spot market has also taken a dovish stance. Goldman Sachs' latest survey of clients shows that as of the week ending June 24, net long positions reached the highest level in three months.
Here is an overview of the latest position indicators in the interest rate market:
Bullish Morgan Stanley Clients
In the week before June 24, Morgan Stanley's overall client survey showed a 1 percentage point increase in net long positions, the largest since March 25. Long positions are the highest since June 3. This week, direct short positions remain unchanged.
Client net long positions rise to the highest level in three months
Option premiums hover above neutral
After the hedging premium for the bond rally rose to the highest level of the year a few weeks ago, the skewness of the yield curve has fallen to slightly above neutral levels. Over the past week, open interest in call options at 111.50 in August has increased significantly, targeting around a 4.10% yield on 10-year Treasury bonds expiring on July 26 As of the close of Monday, the open interest was 128,524 contracts, about twice the 65,470 contracts of the August 110.00 put options.
Asset Management Companies Extend Futures Duration
According to CFTC data as of June 18, asset management companies extended their net position duration by approximately 141,000 10-year US Treasury futures contracts, increasing their overall long-term position to around 7.6 million 10-year US Treasury futures equivalents. Hedge funds, on the other hand, took the opposite view by adding about 186,000 10-year Treasury futures contracts to their net short positions. They increased their net short position on two-year note futures by $5.6 million per basis point of risk, bringing their net short position to a record of over 2 million contracts.
SOFR Options
In the past week, the largest increase in open interest in SOFR options was in the call options at 96.75 and 97.75 for March 2025, related to bullish call spread bets. These options were bought at a price of 4.75 over the past three trading days. Other active strikes this week include 94.875 and 94.75, followed by the put spread of 94.875 - 94.75 for December 25.
SOFR Options Chart
In the SOFR options as of March 25, the most active strike remains at the 96.00 level, equivalent to a 4% rate. Bulk trades involving strikes include SOFR March 25 96.00/95.50/95.00 put options and SOFR September 25 96.75/96.00/95.25 put options. Recent popular trades also include the SOFR December 24 96.00/97.00 call spread, traded in May
