Traders Increase Hedging, Betting That the Fed's Rate Hike Cycle May Be Shallower Than Market Expectations

According to zhitongcaijing APP, traders are seeking protection against a possibility—the Federal Reserve raising interest rates by less than currently priced in by the market. Interest rate swaps currently reflect expectations for three Fed rate hikes of 25 basis points each by June next year. This view was further reinforced after Fed policymakers voted last week to raise the federal funds rate target range by 25 basis points and signaled the need for further hikes to contain inflation.

Meanwhile, this hawkish consensus is prompting some traders to hedge their risks using options linked to the policy-sensitive Secured Overnight Financing Rate (SOFR). Over the past week, there’s been increasing demand for call options on March SOFR futures, indicating growing market interest in safeguarding against a less aggressive policy path from the Fed.

Christian Hoffmann, head of fixed income at Thornburg Investment Management, said: "The market is currently pricing in three rate hikes from now on. I would choose to bet in the opposite direction." "Raising rates four times within a year is a fairly aggressive measure for the current economic backdrop and would have substantial ripple effects on the macroeconomy."

The increase in open interest over the past week indicates that new hedging positions are being established

Oil prices remain a key variable and continue to have a major impact on both the Fed's policy path and market outlook. Driven by factors related to the Middle East conflict, rising crude oil prices recently pushed the yield on the US 10-year Treasury above 5% at one point.

On Tuesday, as Saudi Arabia sought to restore crude oil transport on a key pipeline and investors focused on the diplomats' annual meeting at the United Nations headquarters in New York—hoping to find clues about the reopening of the Strait of Hormuz—US Treasury prices fluctuated alongside oil prices.

George Bory, chief investment strategist for fixed income at Allspring Global Investments, stated that the recent market environment prompted him to add bullish positions in the bond market. And he is not the only one. The latest investor survey from JP Morgan shows that direct long positions have increased to their highest levels since November of last year.

George Bory said: "Higher yields, higher current monetary policy rates, and higher oil prices, essentially all act like a tax on economic growth." "Therefore, some of these pressures may start to emerge in the fourth quarter and even extend into next year." He added that economic slowdown, an easing of Middle East tensions, and a cooling down of artificial intelligence (AI) spending could all lead to fewer Fed rate hikes.

As of Monday’s close, open interest for SOFR call options expiring in March 2027—representing new risk exposure—stood at around 2.7 million contracts. This is about 1 million more than puts of the same maturity, indicating traders are more inclined to hedge on a path where the Fed’s policy stance will be more dovish than what the market currently prices in.

Jeff Schuh, head of rate trading at Constitution Capital, commented: "These capital flows may suggest that the Fed will proceed with one or two cautious rate hikes, but after these hikes, the market may enter a relatively range-bound period."

Open interest for March 2027 SOFR call options is 60% higher than put options

In addition, one standout strike in the March 2027 SOFR options is targeting the overnight rate at nearly 3%, well below the current effective federal funds rate of 3.88%. Achieving this would require the Fed to quickly begin a rate-cutting cycle in early 2027, which few expect to occur at this point.

Below is an overview of various position indicators in the rates market over the past week:

JP Morgan’s US Treasury client survey shows that for the week ending September 21, direct long positions rose by 4 percentage points to the highest level since November last year, while short positions fell by 6 percentage points.

JP Morgan US Treasury all-client position survey

For SOFR option positioning, large new risk exposures appeared at multiple strikes for the March 2027 calls in the SOFR December 2026, March 2027, and June 2027 option series. This includes the 97.00 strike (with 94,262 new contracts) and the 96.25 strike (with 102,713 new contracts), mainly due to substantial buying of SFRH7 96.25/97.00 call 2x3 (ratio call spreads). The market is also seeing demand for similar structures through SOFR March 2027 96.75/97.75 call 2x3 spreads.

However, the most active strike over the past week was the 95.4375 strike, primarily due to a surge in December 2026 put options. This activity included the purchase of SFRZ6 95.9375/95.8125/95.4375/95.3125 put condors.

Most active SOFR option strikes

SOFR options open interest

Thanks to the huge trading volume of SOFR 97.00 call options for March 2027 over the past week, the 97.00 strike has now become the strike with the most open interest across December 2026, March 2027, and June 2027 maturities. Open interest at the 96.50 strike remains elevated, with a significant number of December 2026 call positions still present.

In long-term Treasury contracts, option premiums paid for hedging Treasury futures risks remain tilted toward puts but have moved closer to neutral compared to a few weeks ago. This suggests premiums paid by traders to hedge against a sell-off in the long-end yield curve are declining. Over the past week, skew from the front end to the intermediate tenors has stayed close to neutral levels.

US Treasury option call/put skew