(Bloomberg) — Bond traders are stepping up short bets against Treasuries and buying derivatives to protect against a selloff, positioning for the risk that the Federal Reserve will dial back the market’s expectations for interest-rate cuts this year.
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While the US central bank is all but certain to hold rates steady Wednesday, trading data points to growing concern that its new forecasts will show increased reticence to ease monetary policy.
The December forecasts showed policymakers were penciling in three quarter-point cuts in 2024, but since then the economy has continued to exhibit surprising strength and inflation has held above the Fed’s target.
“The bond market is bracing for a hawkish Fed message Wednesday,” Bryce Doty, senior portfolio manager at Sit Investment Associates, said in a note to clients.
Bond yields have risen this year, saddling investors with fresh losses, as expectations faded that the Fed would ease policy sharply. In late December, futures traders were pricing in virtual certainty the central bank would start cutting rates by Wednesday’s meeting and make a total of about six such moves by the year’s end.
Traders have since reassessed the outlook and are expecting roughly three rate reductions in 2024, putting them in line with the Fed’s so-called dot-plot forecasts from December. But there’s a possibility the latest release will show policymakers expect even fewer cuts, potentially triggering another round of selling.
Tom Simons, a senior economist with Jefferies, said he expects the median policymakers’ forecast will peg the benchmark rate at about 4.88% by the end of the year, implying just two quarter-point cuts. He said that would address some of the easing of financial conditions this year, evidenced by the rally in the stock market.
“If the Fed were to keep rate forecasts unchanged, they would risk another renewed push to even easier financial conditions that would work against their effort to get inflation back down to 2%,” he said in a note to clients.
Speculation that rates will come down later this year continues to be widespread, however, and there remain some signs of bullishness in the Treasury market. JPMorgan Chase & Co.’s latest client survey, for example, showed that while short bets have increased, outright long positions have risen as well and now stand at the biggest since Jan. 29.
But on Monday, two-year Treasury yields hit the highest levels of the year, rising to as much as 4.75%, though they dropped slightly on Tuesday. Bank of America Corp.’s head of interest-rate strategy, Mark Cabana, Tuesday estimated that the two-year yield would rise another 10 basis points if the Fed’s new dot-plot shows just two cuts this year.
The options market has shown investors positioning for such risks. On Monday, there was a big increase in open interest in two-year note futures, consistent with new short positions being set, as well as a large purchase of five-year note options anticipating the cash yield will rise to 4.45% by Friday. It was around 4.3% Tuesday.
Traders have also been targeting protection against a hawkish shift with options linked to the Secured Overnight Financing Rate, which closely tracks the central bank’s policy path. Further out on the curve in Treasury options, there’s also been activity hedging for higher yields.
New Shorts, Longs Unwound
Open interest data over the past week has shown a heavy amount of new short positions added in 10-year note futures, particularly on March 13, when around $3 million per basis point in risk was added. The day before a large amount of long positions appeared to be liquidated into the selloff in the futures. Overall net change in open interest on 10-year note futures last week was roughly +43,000 contracts.
Out of Cash Neutrals
JPMorgan’s latest survey of Treasury clients released Tuesday is more mixed. It shows neutral positions dropping as both long and short positions rose in the week up to March 18. Moreover, the outright long positions are now the biggest since Jan. 29.
Bearish Skew Extends
Into last week’s back-up in Treasury yields, the cost of protection against a bigger selloff rose to the most expensive since the end of February in long-bond futures. In Treasury options, flows have reflected increased demand for protection on higher yields, with a recent stand-out trade including a weekly option targeting a rise in 5-year yields to 4.45% by Friday. Tuesday’s release of open interest data showed this position as new risk.
Asset Manager De-Leveraging
CFTC data in the week up to March 12 showed roughly 183,000 10-year note futures-equivalents of asset manager net-long liquidation, continuing the recent de-leveraging trend out of Treasury futures and potentially into credit. Asset manager net long positioning in Treasury futures is now at its lowest since July, shown by 10-year note futures equivalents.
Basis Trade Is Seen Dwindling as Asset Managers Pivot to Credit
SOFR Options Most Active
The largest three strikes which saw open interest gains benefitted from a large SOFR Jun24 94.9375/94.875/94.8125/94.75 put condor buyer over the past week, a position which stands to benefit from rate-cut pricing coming out of the June policy meeting. There was also demand over the past week for SOFR Jun24 94.875/94.9375/95.00/95.0625 call condor’s. Largest liquidation was seen in the 95.50 strike, supported by last week’s strike adjustment within a SOFR Dec24 structure.
SOFR Options Heat-Map
The most populated SOFR options strike out to the Dec24 tenor is the 95.50 strike, despite a heavy amount of liquidation seen over the past week. Within the 4.5% strike, a large amount of Jun24 puts remain. Other populated strikes include the 95.00, 95.25 and 94.875 where a decent amount of Jun24 puts open interest also remains.
–With assistance from Liz Capo McCormick.
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