(Bloomberg) -- Traders in US futures and options markets are piling on bets that the Federal Reserve will continue cutting rates into next year instead of raising them.
Futures spreads linked to the Secured Overnight Financing Rate, which closely track expected Fed policy, are becoming deeply inverted — a sign that traders are starting to price a more prolonged central bank easing cycle.
Until recently, traders had been wagering that the central bank would resume hiking rates in 2027 after two quarter-point reductions by the end of this year. But a growing debate around the impact of artificial intelligence on the labor market is leading them to reassess this outlook. On Tuesday, Federal Reserve Governor Lisa Cook warned that the central bank may not be able to counter rising unemployment driven by the adoption of AI.
The flattening move in SOFR spreads has accelerated since the end of last week, just as AI disruption fears took a toll on a swath of stocks, setting off a rally in long-dated Treasuries.
"The question is how is AI going to be inflationary and maybe the long end of the curve is sniffing all of this out," said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. "The only inflationary aspect of AI is the building out of data centers and the associated energy needs, and that is known."
The 12-month December 2026 to 2027 SOFR spread dropped into negative on Friday with the inversion deepening on Tuesday to minus 8 basis points, in a sign that investors have flipped from pricing hikes in 2027 to pricing cuts. A record amount of just over 150,000 traded in the 12-month spread over Monday's session.
In the SOFR options market, a similar dovish theme is emerging in trades that are favoring hedging the prospect of multiple rate cuts this year. Those trades picked-up again on Tuesday with one position that's looking to hedge for the policy rate falling to as low as 2% by the end of the year growing in size. Open interest in the December 98.00 calls ballooned to more than 400,000 this week. The swaps market is currently pricing a Fed rate of around 3.1% — or just over two 25-basis point cuts — by year-end, some 110 basis points above the options strike price.
SOFR Trade Targeting 2% Year-End Rate Surges to $40 Million
"There has certainly been a bit of repricing for lower yields after the Fed hits terminal," said Gennadiy Goldberg, head of US rates strategy at TD Securities, with the market "penciling in a more gradual drift higher in yields."
"That could be driven by uncertainty regarding the impact of AI on the labor market, but fluctuations in longer-dated Fed expectations tend to be quite significant, making it difficult to read into them," he said.
Treasury curve metrics also reflect the market's pricing of prolonged rate cuts. The 2- to 5-year spread reached flattest levels since the start of December on Monday, while the richening of the 2s5s30s butterfly was the biggest one day move seen in six months, driven by outperformance in the belly of the curve.
Meanwhile in the cash market, traders are showing a lack of conviction on how to position in Treasuries. JPMorgan's latest client survey covering the week up to Feb. 23 showed the largest amount of neutral positioning since the end of 2024.
US Treasuries slipped across maturities on Wednesday. The 10-year yield was two basis points higher at 4.05%.
Here's a rundown of the latest positioning indicators across the rates market:
JPMorgan Survey
In the week to Feb. 23, clients' short positions were cut by four percentage points and longs reduced by two percentage points. Outright short positions shifted to the fewest amount since December while the level of neutral positioning sits at the most elevated since December 2024.
SOFR Options
Open interest changes across March, June and September SOFR options over the past week saw a large amount of new risk added across a number of Sep26 puts largely due to heavy buying in SFRU6 96.4375/96.3125/96.1875 put flies from 2.25 to 2.5, which was mostly seen last Thursday. The past week has also seen a decent amount of upside via March calls with the SFRH6 96.375/96.4375/96.50 call flies being a popular play.
Broadly, the most populated strike in tenors out to the Sep26 options is the 96.375 level, where there remains a large amount of Mar26 calls, Mar26 puts and Jun26 puts open interest. Recent trades around the top strikes has been demand for SFRH6 96.375/96.4375/96.50 call flies and SFRM6 96.5625/96.4375/96.375 1x3x2 put flies.
Treasury Options Premium
The premium paid to hedge Treasuries risk has extended further to favor calls over puts, indicating traders paying a higher price to hedge a bond market rally over a selloff. The premium is most elevated in the long-end of the curve, where 10-year and long-bond options skew is favoring calls by the most in months.
--With assistance from Michael MacKenzie and Miles J. Herszenhorn.
(Updates prices.)
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