(Bloomberg) -- Traders who are locked into record wagers tied to the Federal Reserve’s expected interest-rate cut Wednesday are risking sharp losses if officials opt for a standard-sized reduction.
Activity in October fed funds futures, which investors are using to bet on this week’s policy meeting, has jumped to the most extreme level of any such contract since the derivative’s inception in 1988, according to data compiled by Bloomberg. The bulk of these new bets are targeting an outsized half-point cut, including a surge of positions put in place this week, the data show.
With the Fed set to begin lowering its target rate, debate among investors has centered on the size of the first cut and the scope of reductions.
While the consensus early last week was that central bankers would opt for a quarter-point cut to start, that’s changed markedly in recent days following media reports and commentary from Former New York Fed President William Dudley suggesting policymakers may just as easily decide on more aggressive action.
Market-implied odds now put the chance of a half-point move at just over 50% ahead of the decision. Meanwhile, recent big gains in benchmark US Treasuries have sent yields sharply lower, with the US two-year yield touching a two-year low of 3.52% this week.
That leaves the market vulnerable to selling pressure if the Fed starts smaller and Chair Jerome Powell telegraphs a gradual approach, said Subadra Rajappa, head of US rates strategy at Societe Generale.
“The market reaction will be much stronger if the Fed cuts by 25 basis points instead of 50 basis points,” she said. “The positioning, the optimism, the easier financial conditions, that sort of narrative could be tested.”
What Bloomberg strategists say...
“Whatever the reaction to the US central bank’s decision investors see little reason to fade further rate cuts — leaving the bias to buy dips.”
— Alyce Andres, US rates/FX strategist
Short-term US Treasuries, which are more sensitive to Fed policy, may be hit the most by any reaction, especially given that they are “already pretty aggressively priced,” said Kathy Jones, chief fixed income strategist at Charles Schwab. “You could back up 10 basis points, 15 basis points pretty easily if it’s 25 basis points, as an initial reaction.”
Soaring volumes in the October fed funds contract have left open interest, or the amount of leverage held by traders, just short of 800,000 contracts. The bulk of the recent activity has targeted a half-point cut, with almost a third of new positions coming over the past two sessions.
In the futures market linked to the Secured Overnight Financing Rate, Monday’s session also saw a huge new trade on a similar theme that stands to benefit from a half-point rate cut.
Elsewhere, broader market sentiment in the the cash market for US Treasuries remains positive, although Tuesday’s JPMorgan Treasury client survey showed a reduction in long positions consistent with risk reduction ahead of the Wednesday risk event. A separate survey from Bank of America also showed investors leaning bullish.
“The global rates rally is driving a perception that long rates is the most crowded trade, exceeding long equities for the first time,” Bank of America strategists wrote in a note.
Here’s a rundown of the latest positioning indicators across the rates market:
JPMorgan Survey
Investor sentiment remains bullish, despite long positions being unwound in the week up to Sept. 16, according to JPMorgan’s Treasury client survey. During that period, long positions dropped 5 percentage points, while shorts rose 4 percentage points leaving net long positions at the fewest in three weeks.
Risk Added in SOFR Options
Over the past week, the 95.875 Dec24 call strike has been active, following buying of the SFRZ4 95.875/96.125/96.375 call fly for new risk as traders extend upside protection from the expired September SOFR options out to the December tenor. There has also seen a heavy amount of new positioning across various SOFR Mar25 put strikes following recent flows including large buying of the SFRH5 95.875/95.625 1x2 put spread and the SFRH5 96.25/96.00/95.75 put fly.
SOFR Options Heatmap
In SOFR options out to the June 2025 tenor, the 95.50 strike remains the most elevated with a vast amount of both Dec24 calls and puts occupying the level. There has been some recent outright buying of Dec24 95.50 puts adding to open interest in the strike.
Hedge Funds Bearish Long-End Treasury Futures
In the week up to Sept. 10, hedge funds added to net short positions in long-bond and ultra-long bond futures by a combined $6.4 million per basis point, CFTC data shows. Overall, leveraged net shorts across the futures strip were extended by roughly 38,000 10-year note futures equivalents. Meanwhile, asset managers continued to extend bullish positioning with their net long rising by roughly 115,000 10-year futures equivalents over the week.
Options Premium Remains Close to Neutral
The premium paid to hedge the market continued to hover near neutral over the past week across tenors, after spiking a couple a few weeks ago to favor call premium as traders looked for a continued market rally. Recent standout flows have included a $18 million position via October 10-year 115.25 puts which expire Friday.
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