Traders Step Up Hedging, Betting Fed's Rate-Hike Cycle May Be Shallower Than Market Expects

Traders are seeking protection against the possibility that the Federal Reserve may raise interest rates by less than what the market is currently pricing in. Interest rate swaps currently reflect expectations that the Fed will raise rates three times by 25 basis points each before June of next year. This view was further reinforced last week after Fed policymakers voted to raise the target range for the federal funds rate by 25 basis points and signaled that further rate hikes would be needed to curb inflation. At the same time, this hawkish consensus is prompting some traders to hedge risk using options linked to the policy-sensitive Secured Overnight Financing Rate (SOFR). Over the past week, demand for call options tied to March SOFR futures has continued to increase, indicating growing interest in protecting against a less aggressive Fed policy path. Christian Hoffmann, head of fixed income at Thornburg Investment Management, said: "The market is currently pricing in three more hikes from here. I would choose to bet in the opposite direction." "Four hikes within a year would be a fairly aggressive response for the current economic backdrop and would have substantial knock-on effects on the macroeconomy." Open interest rose over the past week, indicating that new hedge positions are being established Oil prices remain a key variable and continue to have a major impact on the Fed's policy path and the market outlook. Driven by factors related to the war in the Middle East, the yield on the U.S. 10-year Treasury briefly surged above 5% recently. On Tuesday, as Saudi Arabia sought to restore crude oil shipments through an important pipeline, while investors focused on the annual gathering of diplomats at the United Nations headquarters in New York for clues on progress toward reopening the Strait of Hormuz, U.S. Treasury prices fluctuated along with oil prices. George Bory, chief fixed income strategist at Allspring Global Investments, said the recent market environment prompted him to increase bullish positions in the bond market. And he is not the only one doing so. JPMorgan's latest investor survey showed that investors' direct long positions increased, reaching the highest level since November last year. George Bory said: "Higher yields, a higher current policy rate, and higher oil prices are all essentially a tax on economic growth." "So some of these pressures may eventually begin to show up in the fourth quarter, and possibly extend into next year." He added that an economic slowdown, easing tensions in the Middle East, and cooling AI spending could all lead to fewer Fed rate hikes. As of Monday's close, open interest in SOFR call options expiring in March 2027 - that is, new risk exposure - was about 2.7 million contracts. That was about 1 million more than put options with the same expiry, indicating that traders are more inclined to use hedges to bet that the Fed's policy path by then will be more moderate than what is currently priced in. Jeff Schuh, head of rates trading at Constitution Capital, said: "These flows may mean that the Fed has one or two more cautious hikes left, but after those hikes, the market may enter a relatively range-bound period." Open interest in March 2027 SOFR calls is 60% higher than in puts In addition, among March 2027 SOFR options, one prominent position targets an overnight rate close to 3%, well below the current effective federal funds rate of 3.88%. To reach that target, the Fed would need to launch a rapid rate-cutting cycle in early 2027, which few currently expect. The following is an overview of various positioning indicators in the rates market over the past week: JPMorgan's U.S. Treasury client survey showed that in the week ended September 21, investors' direct long positions increased by 4 percentage points to the highest level since November last year; at the same time, short positions decreased by 6 percentage points. JPMorgan U.S. Treasury all-client positioning survey In terms of SOFR options positioning, among SOFR December 2026, March 2027, and June 2027 options, multiple strike prices in the March 2027 calls saw large new risk exposure over the past week, including the 97.00 strike (up 94,262 contracts) and the 96.25 strike (up 102,713 contracts). This was mainly due to heavy buying of SFRH7 96.25/97.00 2x3 call spreads. The market also generated demand for similar structures through SOFR March 2027 96.75/97.75 2x3 call spreads. However, the most actively traded strike over the past week was 95.4375, mainly due to a surge in December 2026 puts, with flows including buying SFRZ6 95.9375/95.8125/95.4375/95.3125 put condors. Most active SOFR option strike prices SOFR options open interest Due to the huge trading volume in SOFR March 2027 97.00 calls over the past week, the 97.00 strike is now the strike with the largest open interest across the December 2026, March 2027, and June 2027 expiries. Open interest at the 96.50 strike also remains high, with a still-large amount of December 2026 call positions. In long-term Treasury contracts, the option premium paid to hedge U.S. Treasury futures risk still leans toward puts, although it is now closer to neutral than it was a few weeks ago. This indicates that the premium traders are paying to hedge a selloff in the long end of the yield curve is declining. Over the past week, skew from the front end to the belly has remained close to neutral. U.S. Treasury options call/put skew