Options market declares war on Fed rate hikes, large funds buy against the script

Author: Xiao Yanyan, Jintou Data

As the Federal Reserve's future policy path unfolds, disagreements between the derivatives market and the broader interest rate market are widening. Some options traders are beginning to bet that the market's previous pricing of rate hikes may be too aggressive, especially regarding expectations of consecutive tightening policies later this year.

This judgment aligns with recent changes in trading behavior. The day after the Federal Reserve announced the June interest rate decision, trading volume in contracts linked to the Secured Overnight Financing Rate (SOFR) rapidly doubled compared to the previous day. In these trades, many bets are targeting fewer actual rate hikes than the levels reflected in the broader money market.

Since this rate closely reflects policy rate expectations, the concentrated appearance of such trades indicates that funds are positioning for scenarios where the actual number of rate hikes may be lower than the market-implied path—and the money market had previously generally expected, under the leadership of Fed Chair Kevin Warsh, that the U.S. would enter a phase of significantly rising borrowing costs.

The trading structure shows that many positions are intended to hedge against the risk of policy tightening being less aggressive than expected, and such operations have continued this week. SOFR-related products are also important risk management tools for the approximately $31 trillion U.S. Treasury market, which has undergone a significant reassessment since late February, following U.S.-Israel military actions against Iran.

The rise in energy prices driven by the conflict has become a key variable. Rising oil prices have strengthened inflationary pressures, pushing U.S. Treasury yields higher and prompting traders to increase their bets on rate hikes. Even as this occurs, President Trump has publicly called for lower borrowing costs, but Warsh emphasized prioritizing price stability, a stance that further reinforced market expectations of tightening last week.

However, as pricing continues to move upward, doubts have also emerged. Molly Brooks, U.S. interest rate strategist at TD Securities, pointed out that the path reflected in the interest rate swap market, which suggests bringing forward the first rate hike to the July meeting, "seems a bit excessive," although she considers the possibility of rate hikes later in the year to be reasonable.

She explained that even the most hawkish officials might wait for more data on employment and inflation before acting. "We do believe that the timing of rate hikes is mispriced."

Longer-term trades also reflect a need to hedge against reverse volatility. Recently, the market has been heavily buying call options expiring in August, with nearly $30 million in volume on Monday and Tuesday alone. This increased demand for "upside protection" essentially aims to guard against a rebound in bond prices—if such a scenario occurs, the 10-year U.S. Treasury yield could fall back to 4.4% or lower in the coming weeks. Currently, the yield is about 4.5%.

Sentiment from the cash market has not fully aligned with hawkish expectations. A client survey of the U.S. Treasury market conducted by JPMorgan on Tuesday showed that even after Warsh's hawkish policy stance, investors remain divided on the future direction of interest rates. The survey, covering the period from last Tuesday to this Monday, indicated that neutral positions had risen to a two-month high, while both long and short positions had decreased.