The market is using real money to fully price in the rate cut expectations! The Fed's rate cut in September is just a step away from official announcement

In the U.S. bond trading market, bond traders are taking on record bullish risks, betting on the continued rebound of the U.S. Treasury market and the potential long-term bull market, with the massive betting scale driven mainly by the expectation of the Federal Reserve's first rate cut in over four years. From the perspective of betting on the U.S. Treasury market, bond traders have priced in almost a 100% probability of a 25 basis point rate cut in September, with similar rate cut expectations for November and December being increasingly priced in by more traders.

Ahead of the central bank's annual economic symposium in Jackson Hole, Wyoming on Friday evening Beijing time, the leverage positions in U.S. Treasury futures have reached historic highs. During this event, Federal Reserve Chairman Jerome Powell will deliver a crucial speech and provide more insights into the Fed's monetary policy path for the remainder of the year.

For the global stock markets that experienced a "super rebound" last week, the Jackson Hole central bank annual meeting held on Friday evening Beijing time is considered a "key test", where policymakers such as Fed Chair Powell and Bank of England Governor Bailey will deliver important speeches. During last Friday's trading session, the options market priced in high volatility of over 1% for the S&P 500 index this Friday, betting that the benchmark index will experience volatility exceeding 1% regardless of whether it rises or falls.

"If traders hear the heavyweight signal of a rate cut coming, the stock market will react positively," said Eric Beil, Managing Director of Steward Partners Global Advisory. "However, if traders and investors do not hear the positive information they want, the stock market after the rebound may face massive selling."

"The market is very confident that a rate cut is imminent," Beil said. "If Powell does not emphasize this as the path forward, it will be a huge trigger."

Tom Hainlin, Chief Investment Strategist at US Bank Wealth Management, said, "Looking back at past speeches from the Jackson Hole symposium, we are unlikely to get very definitive rate cut comments from Powell."

Bill Dudley, former president of the New York Federal Reserve Bank, said that Fed Chair Powell may suggest that overly tight monetary policy is no longer necessary. However, he expects Powell not to hint at the magnitude of the first rate cut and the specific timeline, especially since a crucial non-farm payroll and unemployment report will be released on September 6, providing a more comprehensive assessment for Fed policymakers before making the next policy decision on September 18.

Data from the Chicago Mercantile Exchange Group Inc. (CME Group Inc.) and Bloomberg analysis show that last week, the open interest in futures markets, which represents the overall risk exposure for traders who can choose to go long or short, reached a record high of nearly 23 million contracts for 10-year U.S. Treasury futures. For every one basis point change in the underlying cash instrument, the risk is approximately $1.5 billion

Leverage - Investors' Risk Exposure in Treasury Futures Hits Historic High

As traders bet on an approaching rate cut cycle, they have been heavily buying US Treasury futures. This increase aligns with the growing bullish bets on the Treasury market over the past few weeks, indicating a belief that the Federal Reserve will significantly cut rates this year and in 2025. According to the statistics from the Commodity Futures Trading Commission (CFTC) as of the week ending August 13, asset management companies have increased their net long positions in 10-year US Treasury futures by approximately 120,000 contracts.

While many signs suggest that most leverage positions involve asset managers going long on Treasury futures, some of these can be attributed to basis trading, a popular hedge fund strategy where traders profit from the price difference between cash Treasuries and futures.

Given that this strategy involves borrowing through the repo market, if overall lending conditions tighten, traders may be forced to unwind positions to repay loans. Such rapid unwinding of positions could lead to significant volatility in the Treasury market.

It is worth noting that cautious traders who have been concerned that the timing and scale of Fed rate cuts may fall short of market expectations have been betting on various scenarios that could unfold this year. Just two weeks ago, the swaps market was pricing in a 50 basis point rate cut at the September meeting with the risk of an emergency cut, but some traders have consistently stuck to a 25 basis point cut. Currently, with incredibly strong retail sales data and initial jobless claims suggesting a labor market outlook better than expected, the expectation of a 25 basis point rate cut next month is almost 100% priced in.

The spot trading market has already shown signs that the previously bullish bets are starting to unwind ahead of the Jackson Hole meeting. A US Treasury client survey report released by Wall Street major bank JPMorgan Chase on Tuesday local time showed that related net long positions have decreased to the lowest level in a month.

Here is an overall overview of the latest positioning indicators in the interest rate market:

JPMorgan Chase's Latest Survey Data

In the week ending August 19, JPMorgan Chase's US Treasury client survey showed a 6 percentage point decrease in long positions, but still maintained a net position favoring long sentiment for at least over a month, while short positions increased slightly by 5 percentage points within the week, albeit at a slower pace than long positions.

JPMorgan Treasury Bond Client Position Survey - Clients' Completely Long Positions in August Hit Highest Since Last December

Hedging Premium Eases

After a bullish premium emerged in the U.S. Treasury market a few weeks ago as traders sought a continued rebound, the premium paid to hedge against market volatility has continued to fall back to neutral levels. Tuesday's government bond options flow included a high premium long-term options volatility bet of up to $5 million through October options by the buyer of the strangle, which will expire two days after the Federal Reserve's monetary policy announcement on September 18. In the latter part of last week, there was a significant amount of trading flow around September and October 10-year Treasury put options, indicating that some traders are targeting higher U.S. 10-year Treasury yields.

Changes in Fund Flows

Although trading volumes for SOFR futures and options have declined over the past few trading days, fund flows for the September term are now mainly focused on bets of a 25 basis point Federal Reserve rate cut, moving away from the possibility of a 50 basis point rate cut at the September meeting. Looking at last week's fund flow data, overall bets on a 50 basis point rate cut have been gradually unwound, leading to a significant liquidation of December 24 and March 25 put options. The largest cash-out in the past week occurred in the exercise scale of call options at the 97.00 and 96.00 levels for Dec24, where the existing call option spread structure at the 96.00/97.00 levels was unwound and reversed to a new 96.50/97.50 position.

Most Active SOFR Option Exercise Prices - Comparison of Top 5 and Bottom 5 Weekly Net Changes in SOFR Option Exercise Prices

SOFR Option Heat Map

In the SOFR options expiring in March 2025, the exercise point of 95.50 is currently the highest among outstanding contracts, boosted by trading in call options at 96.00/96.50/97.00/97.50, with call option prices for December 25 rising over the week SOFR Options Open Interest - Top 20 Liquidity Positions as of March 2025

From the statistics of SOFR options open interest data, it seems that the SOFR options market has shifted from betting on a 50 basis point rate cut by the Fed to a comprehensive adjustment of 25 basis points. The distribution of call and put options at the 95.50 level shows that the market's expectation of the future Fed benchmark interest rate staying at a low level has significantly strengthened in recent days.

The distribution of these option levels indicates that the vast majority of participants in the SOFR options market expect the Fed to have started a rate cut cycle since September, betting that the rate cut this year could be as high as 75 basis points and may reach a certain bottom rate level by early 2025. Therefore, investors are betting on these possible rate paths by purchasing corresponding SOFR options while striving to hedge related risks.

During the Fed rate cut cycle, traders may be more inclined to capture profit trading opportunities of rate declines through the SOFR options market, while adjusting positions to deal with market uncertainty. The increase in call options holdings reflects an optimistic bet on the trend of rate cuts, while the increase in put options holdings may be a similar hedging strategy against potential rate trend uncertainties.

Divergence in Positions on Treasury Futures between Asset Management Institutions and Hedge Funds

In the week ending August 13, there were significant changes in some large positions, with global asset management companies extending the duration long positions of approximately 120,000 10-year US Treasury futures contracts. This indicates that these large asset management institutions are optimistic about the prospects of US Treasury prices, believing that rates may continue to fall, or at least remain low for some time in the future. Therefore, they choose to extend the duration of their portfolios by holding longer-term bonds or corresponding futures positions to benefit from falling rates.

However, hedge funds hold a completely opposite view, increasing the net duration short positions of approximately 315,000 10-year US Treasury futures contracts. Data shows that hedge funds have a bearish view on 10-year US Treasury futures, driving their overall net short position in US Treasury futures contracts to exceed 2 million contracts, setting a historical record. Asset management institutions may anticipate that the Fed will adopt a more accommodative monetary policy in the future, or believe that economic growth may slow down, thereby lowering benchmark interest rates. They bet that this will lead to a decrease in long-term Treasury bond yields, an increase in prices, hence they have increased their long positions.

However, hedge funds may believe that the current US economy and labor market are still resilient, and the Fed will not significantly lower rates as expected by the market, but will take gradual and slow rate cuts. Therefore, they have increased short positions, betting that long-term bonds will experience price declines at some point in time.