Expectations for a significant rate cut by the Federal Reserve disappear as short interest in US bonds begins to emerge

Zhitong Finance APP noticed that traders are starting to bet that the US Treasury market will suffer losses because they expect the Federal Reserve to cut interest rates at a slower pace in the future.

Since the strong performance of the September employment report released late last week, bond traders have been abandoning long positions in multiple futures contracts linked to the Secured Overnight Financing Rate (SOFR). This indicates that bullish bets on a series of significant rate cuts this year and early 2025 have been unwound.

At the same time, short bets are starting to emerge. A financial client survey by JP Morgan showed that this has led to the largest direct short position in the spot market since February 2023.

Citigroup strategist David Bieber wrote in a report on Tuesday, "The market has a preference for new short risks ahead of this week's inflation data release."

Since the release of the employment report, the open interest data for SOFR futures contracts (i.e., the number of positions held by futures market traders) has significantly decreased. Data released by the Chicago Mercantile Exchange on Tuesday showed a reduction of approximately 223,000 contracts within the December 2024 maturity, equivalent to a risk of $5.6 million per basis point. During this period, the contract was heavily sold off, indicating that bullish bets have been erased as traders reprice the Fed's policy path for this year as less aggressively dovish.

Key inflation data to be released on Thursday may further disrupt traders' bets on monetary policy, with short positions forming ahead of this. It is expected that the latest Consumer Price Index (CPI) will further slow down, but if the index strengthens, investors may still shift heavily towards short positions.

The market currently expects the Fed's policy meeting on November 7 to cut rates by about 21 basis points, with a total of 50 basis points cut in the remaining two meetings this year. Before the release of non-farm payroll data, the rate cut for the December meeting is expected to be around 66 basis points.

Long positions in the spot market are also disappearing. JP Morgan's latest client survey showed that traders' net short positions appeared for the first time since April 2023.

Meanwhile, since the release of non-farm payroll data last Friday, new positions in the SOFR options market have been leaning towards hedging, with the goal of the Fed gradually cutting rates by 25 basis points in November and then pausing in December.

JP Morgan Survey

As of the week ending on October 7, JP Morgan's client long positions decreased by 9 percentage points, while short positions increased by 3 percentage points. This resulted in the largest short position since February 2023. Neutral positions remained at a high of 67 percentage points, rising by 6 percentage points this week

Most Active SOFR Options

The biggest position change in the past week occurred in the strike related to the December 2024 put options. Following last Friday's employment report and the subsequent repricing of the Fed's policy path, traders sought to increase their bearish positions. A notable flow was a significant purchase of the 95.5625/95.4375 put option spread for December 24th, with the aim of only a 25 basis point rate cut at the remaining two policy meetings this year.

SOFR Options Heatmap

In the SOFR options expiring in June 2025, the 95.50 strike remains the highest, with a large presence of both call and put options at that level for December 24th. Recent flows around exercise include direct buying and downward activity, including buying the SFRZ4 95.625/95.50 put option spread and the SFRZ4 95.5625/95.4375 put option spread.

Hedge Funds Covering Short Interest

CFTC data shows that in the week ending October 1st, leveraged funds covered approximately 57,000 net short positions in 10-year Treasury futures equivalents. During the same period, asset management companies added around 152,000 net long positions in 10-year Treasury futures equivalents. In SOFR futures, for every basis point of risk, asset management companies would close out around $4.4 million.

Bond Put Option Premiums Rising

The premium paid to hedge the Treasury market is once again tilting towards put protection, indicating traders are paying higher premiums to hedge against selling in the Treasury market during a rebound. The highest premium is at the long end of the yield curve, which can be seen from the bias towards put options in long-term bond options This shift triggered market sell-offs, with the 10-year US Treasury yield rising to a high of 4.05% on Tuesday, the lowest level since early August.