Interest rate futures inversion warning: Traders betting on "continued rate cuts" instead of "rate hikes next year," why did market expectations for the Fed change overnight?

Traders in the futures and options markets in the United States are heavily betting that the Federal Reserve will continue to cut interest rates until next year, rather than restarting rate hikes. The futures spread linked to the secured overnight financing rate (which closely tracks market expectations of the Fed's policy) is becoming deeply inverted signaling that traders are starting to price in a more prolonged period of central bank easing. Until recently, traders were betting that after the Fed completes two 25 basis point rate cuts by the end of this year, it would resume rate hikes in 2027. However, the increasingly intense discussions surrounding the impact of artificial intelligence on the labor market are prompting them to reassess this outlook. On Tuesday, Fed Governor Lisa Cook warned that the central bank may be unable to counter the rise in unemployment caused by the widespread application of AI. Since late last week, the flattening trend of the SOFR spread has accelerated, coinciding with concerns about the disruptive impact of AI dragging down a range of stocks and sparking a rise in long-term Treasury bonds. "The question is, how will AI drive inflation, and perhaps the long end of the yield curve is sensing all of this," said Brandywine Global Investment Management portfolio manager Jack McIntyre. "The only aspect of AI that could potentially drive inflation is the construction of data centers and the related energy demand, which is known." The 12-month SOFR spread from December 2026 to December 2027 slipped into negative territory last Friday, and on Tuesday, the inversion deepened further to -8 basis points, indicating that investor expectations have shifted completely from rate hikes in 2027 to rate cuts. During Monday's trading session, the trading volume of this 12-month spread set a record of over 150,000 contracts. In the SOFR options market, similar dovish themes are emerging, with trading leaning towards hedging the prospect of multiple rate cuts this year. These trades became active again on Tuesday, with one position continuing to expand, aiming to hedge the possibility of policy rates falling to as low as 2% by the end of the year. The open interest in the call options expiring in December at 98.00 surged to over 400,000 contracts this week. Currently, the market is pricing in a year-end Fed rate of around 3.1%, just slightly higher than two 25 basis point rate cuts - about 110 basis points higher than the strike price of this option. "After the Fed touches the terminal rate, the market certainly shows some signs of repricing towards lower yields," said Gunatilake Goldberg, head of U.S. interest rate strategy at Credit Suisse, noting that the market "expects yields to gradually rise more tamely." "This may be due to uncertainty about the impact of AI on the labor market, but volatility in the market's longer-term expectations for the Fed is often quite high, making it difficult to make a definitive interpretation," he added. Various indicators of the Treasury yield curve also reflect market pricing for continued rate cuts. The 2-year to 5-year Treasury yield spread reached its flattest level since early December on Monday, and the steepening of the 2s5s30s butterfly spread hit its largest single-day increase in six months due to strong performance in the middle of the curve. Meanwhile, in the spot market, traders appear hesitant about how to position themselves in the Treasury market. The latest client survey from JPMorgan as of the week ending February 23 showed that the proportion of investors holding a neutral stance reached its highest level since the end of 2024. Here is an overview of the latest position indicators in the interest rate market: JPMorgan Survey In the week ending February 23, clients reduced their short positions by 4 percentage points and long positions by 2 percentage points. Pure short positions fell to their lowest level since December, while the proportion of neutral positions rose to its highest level since December 2024. SOFR Options Over the past week, changes in open positions for March, June, and September SOFR options showed a significant increase in risk concentrated in multiple Sep26 puts, primarily due to a large purchase of SFRU6 96.4375/96.3125/96.1875 put butterfly arbitrage last Thursday (price range 2.25 to 2.5). Over the past week, there has also been a considerable amount of bullish betting through March call options, with the SFRH6 96.375/96.4375/96.50 call butterfly arbitrage being a popular choice. Overall, for the Sep26 option, the most concentrated strike price across the maturities is the 96.375 level, where there are still a large number of open contracts for Mar26 call options, Mar26 put options, and Jun26 put options. Recent trading around the top strike price includes demand for SFRH6 96.375/96.4375/96.50 call butterfly arbitrage and SFRM6 96.5625/96.4375/96.375 1x3x2 put butterfly arbitrage. Treasury Options Premium The premium paid to hedge Treasury risks has further widened, with the cost of call options exceeding put options, indicating that traders are paying a higher price to hedge against a rise (rather than a fall) in the bond market. This premium is most apparent at the long end of the curve, with skew indicators for 10-year and long-term bond options showing that the popularity of call options has reached the highest level in months.