(Bloomberg) -- The bullish tone in the US bond market following two benign inflation reports has traders of interest-rate options scrambling to exit positions bought in anticipation of at least one increase by the Federal Reserve this year.
Despite a setback for Treasuries Thursday as oil prices and European bond yields climbed, the market for options linked to the Secured Overnight Financing Rate has continued to be dominated by selling of puts. SOFR tends to rise and fall with the Fed's policy rate, and options on it are a main vehicle for positioning for changes in the rate.
"I think this is a function of the market coming around to the fact that hikes are not a foregone conclusion," said Christopher Hodge, chief US economist at Natixis. "Two straight well-below-consensus prints and a rosier inflation outlook means that the current policy may be sufficiently restrictive."
Reports on US consumer and producer prices, released Tuesday and Wednesday respectively, showed more deceleration that economists had estimated. As a result, the outlook for Fed policy shifted from two quarter-point hikes by mid-2027, including at least one this year, to include the possibility of just one hike, or none.
The interest-rate swaps market prices in just four basis points of tightening for the next Fed policy decision on July 29, or about 16% of a quarter-point hike. At the start of the week, it priced in about 40% of a July increase. December contracts price in about 29 basis points of tightening, down from 43 basis points at the start of the week.
That has collapsed demand for hedges for rate hikes, leading traders to sell put options acquired in recent weeks.
Selling of puts, particularly ones expiring in September and December, continued to dominate SOFR options trading during US hours Thursday. Similar activity on Wednesday resulted in open-interest declines, suggesting that the sales were done to exit positions rather than to set new ones.
Oil prices remain a key driver of hedging activity for Fed policy decisions meetings, however, because of their potential to re-ignite inflation. They've risen over the past week after the collapse of a ceasefire between the US and Iran, offsetting the downward pressure on Treasury yields from the benign inflation data.
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