(Bloomberg) -- Traders in the fed funds market are ramping up bets that the Federal Reserve will start raising interest rates as soon as July, a previously unthinkable move that risks being derailed by a series of economic data.
Chances of a rate hike at next month's policy meeting are still low, with interest rate swaps pricing in about nine basis points of a quarter point hike, or roughly a 36% probability. Still, that's up from nearly zero before new Fed Chairman Kevin Warsh put the focus on price stability.
Open interest, or the amount of new trading positions held by investors, in the August fed funds futures has rapidly ascended since the June 17 policy meeting. The aggressive build-up of new positions is broadly skewed toward sellers, suggesting that traders are shorting the contract, a position that stands to benefit if odds of rate increases continue to rise.
The wagers are gaining traction even as options traders were earlier looking to hedge the number of interest rate increases priced in. These could come into question as soon as Thursday when labor market data are due. Any signs of weakening jobs growth could trim July rate hike odds, putting at risk the newly-established short positions.
Open interest in the August fed funds futures, which track the July 29 policy announcement, has risen from around 454,000 contracts the day before the June policy announcement to almost 590,000 as of Monday's close, or a gain of around 30%. Daily volumes have consistently traded above average during the period, since Warsh opened the door to two-way risks around central bank policy decisions.
Further out the curve, appetite is emerging to enter into more bullish positions on expectations long-end Treasuries will outperform. This week's JPMorgan Chase & Co. client survey showed a rise in outright Treasury longs, pushing net positioning to the most bullish in seven months.
"Longer-term Treasury yields appear to have peaked in mid-May, with long-duration bonds delivering positive returns even as equity markets have moved sideways with elevated volatility," said Jason Vaillancourt, chief portfolio strategist at Columbia Threadneedle Investments.
The shift toward a more favorable view of long-dated Treasuries could further narrow the gap with short-term yields which are rising on rate-hike bets, flattening the yield curve. The spread between 2- and 10-year yields has sunk by around 15 basis points since the June policy meeting and currently sits just inside the yearly lows reached last week.
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Priya Misra, portfolio manager at JPMorgan Asset Management, said a flattening curve "reflects that the market's balance of risks shifted from the labor market to inflation."
Treasuries were steady on Wednesday, with the 10-year yield at 4.46% while the two-year yield was at 4.17%.
A raft of data due in coming weeks, including the June employment and consumer prices reports, will help shape the direction of the curve and traders' views on interest rate hikes.
"If we get continued strong inflation prints and strong labor data, the curve can continue to flatten as more hikes can get priced in," Misra said. "Given my view that peak inflation is behind us, I don't love flatteners here but it may well be the pain trade."
Here's a rundown of the latest positioning indicators across the rates market:
JPMorgan Treasury Client Survey
In the week up to June 29, investor long positions climbed 7 percentage points in a shift out of neutrals with shorts unchanged. As a result, clients' net long position has risen to the most since November last year.
SOFR Options Positioning
Across SOFR Sep26, Dec26 and Mar27 options there has been a wave of Sep26 puts added over the past week, boosting open interest across a number of strikes. Stand out flows have included buyer of SFRU6 96.375/96.25/96.0625/95.9375 put condors, buyer of SFRU6 96.3125/96.25/96.00/95.9375 put condors and buyer of SFRU6 95.9375/95.8125/95.4375/95.3125 put condors. The 96.25 strike has also been active with flows including SFRU6 96.25/96.375 1x2 call spreads and SFRU6 96.25/96.3125/96.375 call trees.
The 96.50 strike remains the most populated strike, where a large amount of Sep26 calls and Dec26 calls open interest remains. There was also a decent rise in open interest across 96.75 Sep26 calls over the past week, with the strike being bought outright in good size at 1.25 ticks.
Treasury Options Skew
The premium paid to hedge Treasury futures has gravitated toward neutral over the past week across long-bond futures while the front-end and belly of the curve has remained close to neutral. The move indicates traders currently seeing equal risk of both a rally and selloff across the Treasuries curve.
--With assistance from Michael MacKenzie.
(Adds Treasury prices in 10th paragraph.)
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