Are market expectations too conservative? Bond traders expect the Federal Reserve to cut interest rates four times in 2025

The Zhitong Finance APP noted that bond traders have been increasing their bets on options and futures, believing that the Federal Reserve is about to signal a rate cut next year that exceeds market expectations.

A quarter-point rate cut on Wednesday has almost become a foregone conclusion, so the update of the Fed's quarterly forecast will be the focus of attention. In September, officials' median forecast for their policy path (known as the dot plot) indicated that rate cuts this year and next would total one percentage point.

However, due to persistently high inflation rates, Wall Street banks have begun to anticipate that the Fed may cut rates one less time next year, meaning a total cut of 0.75 percentage points. Some predict that the Fed may only cut rates by 0.5 percentage points, a level that roughly aligns with swap market pricing.

But in terms of interest rate options, some traders are betting that the market's view is too hawkish, and the Fed will be closer to its September forecast: equivalent to four rate cuts in 2025, each by 25 basis points, which would imply a target federal funds rate of 3.375%.

These traders may have considered how potential signs of weakness in the labor market increase bets on further easing by the Fed, as well as how U.S. Treasury bonds rose earlier this month due to data showing an unexpected increase in the unemployment rate.

In options linked to the secured overnight financing rate, which is highly sensitive to Fed policy expectations, demand is concentrated on dovish bet structures targeting early 2026, expiring early next year. If the central bank's policy forecast is more dovish than the market expects, these positions will benefit.

Meanwhile, traders are increasing their positions in federal funds futures. Open contracts expiring in February have risen to record levels, closely tied to the Fed's policy statements in December and January. Recent fund flows around this timeframe have tended to favor buying, indicating that new bets will benefit from a rate cut in December, followed by further easing in the subsequent decision on January 29.

Morgan Stanley's buy recommendation for February federal funds rate contracts this month seems to have driven bullish activity. Strategists suggest that investors should prepare for a higher market-implied probability of a 25 basis point rate cut on January 29. Assuming the Fed's rate cut on Wednesday aligns with expectations, the market has currently priced in about a 10% chance of a rate cut next month.

Open contracts in federal funds futures rise ahead of the Fed meeting.

Positions outside the curve remain balanced, as traders began to deleverage before last week's consumer price data release. This week, a survey by JPMorgan showed that clients' neutral positions are at their highest level in a month, indicating that they have shed chips ahead of Wednesday's decision and before the end of the year.

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

JPMorgan Financial Client Survey

As of the week ending December 16, JPMorgan's latest survey shows that short positions have decreased by 2 percentage points, shifting to neutral positions, which are currently at their highest level in a month The long positions remained unchanged this week.

Neutral positions rose to the highest level in a month.

Treasury options premiums favor put options

In the past week, the cost of hedging against the long sell-off of the U.S. Treasury yield curve has increased. The skew of long bond options favors put options, reaching the highest level since the first week of November. This comes as the 30-year Treasury yield hit its highest level since November 18 on Tuesday. In terms of options, the flow of funds seems to have muted the changes in skew, with an increase in demand for call structures over the past week. One example is the February call options targeting a 10-year Treasury yield of 4% by the end of January, currently around 4.4%.

Most active SOFR options

In the past week, there has been a significant increase in positions for the Sep25 contract SOFR options compared to clearing. In recent trades, open contracts at a strike price of 95.875 surged, including buyers of the SFRH5 95.625/95.875/96.125 call options, while selling the SFRH5 95.8125 put options, along with recent demand for the SFRH5 95.8125/95.875/95.9375 2x1x1 call options. Demand at the 95.25 strike price also increased, primarily due to active direct purchases of the SFRH5 95.25 put options, which are seen as new risks. The rise in demand at the 95.625 strike price is largely attributed to the buying of the SFRM5 96.00/96.125 call spread, alongside the selling of the SFRM5 95.625/95.4375 put spread.

SOFR options heatmap

Among the SOFR options for the quarterly period from March 25 to September 25, the 96.00 strike price has the most activity, primarily due to a large number of put options at that price level on June 25 Recently, the capital flow around the strike price includes buyers of the June 25 96.00/96.125 call spread and sellers of the June 25 95.625/95.4375 put spread, the latter of which traded new risks on Friday. A large number of open positions are also located at the 95.875 strike price, benefiting from the call option activity on March 25, which includes buyers of the SFRH5 95.625/95.875/96.125 call options and sellers of the SFRH5 95.8125 put options.

CFTC Futures Positions

CFTC data shows that as of the week ending December 10, hedge funds covered their short positions on the long end of the U.S. Treasury curve. During the reporting week, hedge funds covered approximately 65,000 net short positions equivalent to 10-year Treasury futures across the entire futures market, while asset management companies increased their net long positions by about 18,000 equivalent to 10-year Treasury futures. Asset management companies are most optimistic about Treasury futures with maturities over 10 years, with their net long positions increasing by about $2.8 million per basis point. In this week's SOFR futures, hedge funds increased their net long positions, while asset management companies increased their net short positions.