Rate Options Show Rising Bets on a Half-Point Fed Cut This Month

(Bloomberg) -- Rate options traders stepped up wagers that the Federal Reserve will kick off its easing cycle with a half-percentage-point cut this month, reflecting the increasing speculation that policymakers will act aggressively to keep the economy from sputtering.

Options tied to the Secured Overnight Financing Rate show that open interest, or the amount of positions owned by traders, has surged across a number of call contracts that expire on Sept. 13, five days before the central bank’s post-meeting announcement.

The positions would pay off if Friday’s employment report and next week’s consumer price index reading show the labor market and inflation are cooling enough to justify a more rapid approach to easing policy. Right now, swaps contracts put about a one-third chance on the Fed cutting its key rate by a half percentage point this month.

“The labor market has slowed down, and it is now getting the Fed’s attention,” said Priya Misra, portfolio manager at JPMorgan Asset Management. “I see a very strong case for cutting rates initially in 50 basis point increments, given that the funds rate is 5.25-5.5%, the economy is slowing down and the lags between monetary policy and the economy are famously long and variable.”

The bond market has rallied strongly, driving the 10-year Treasury yield back toward last month’s lows, when unexpectedly weak job growth kindled worries that the US was edging toward a recession. JPMorgan Chase & Co.’s survey found that clients have stepped up bullish Treasury bets and pared back short positions.

Economists predict data on Friday will show the pace of job creation rebounded slightly to about 165,000 positions in August, enough to trim the unemployment rate but still far less robust than the growth seen earlier this year.

The Fed cut interest rates by 50 basis points or more during the onset of the pandemic, the credit crisis, and in the aftermath of the dot-com stock-market collapse. The need for such haste looks less clear cut now, however, with the economy still growing and stock prices not too far below this year’s peaks even after the recent slide.

But the options trading wagering on such a move accelerated after Fed Chair Jerome Powell’s Jackson Hole address, when some took his language as leaving the door open for that approach.

Traders have a history of being burned recently by bets on the Fed’s path, so many are still mindful of the risk. At the end of 2023, for example, markets rallied strongly on anticipation that its cuts would start early this year, only to see those gains evaporate when the economy exhibited surprising strength.

“The market is split on whether it’s going to be 25 or 50 basis points for the inaugural September cut,” said Jonathan Cohn, head of US rates desk strategy at Nomura Securities International.

“It almost completely depends on the outcome from the employment report,” he said. “If certain thresholds are met with respect to the unemployment rate and with respect to layoffs, then 50 basis points is absolutely on the table.”

Here’s a rundown of the latest positioning indicators across the rates market:

JPM Survey

In the week up to Sept. 3, a rise in long positions and drop in short positions increased the net-long stance among JPMorgan clients by seven percentage points. The outright long positions rose to the most in two weeks.

Traders Target Half-Point Cut

The weekly swing in options open interest continues to be driven by a build-up of September calls across multiple strikes which stand to benefit from a 50 basis point central bank cut at the Sept. 18 policy meeting. Tuesday’s session saw the momentum extend, as familiar call spread and condor structures were bought over the session which open interest showed as new risk.

SOFR Options Heatmap

In SOFR options out to the March 2025 tenor, call option strikes around a 95-handle remain heavily populated due to upcoming risk events of payrolls on Friday, next week’s CPI data and ahead of the Fed meeting. The past few sessions have seen a surge of demand across multiple upside hedges around the September options.

Positioning Swings in Futures

Large positioning shifts were seen in Treasury futures among both asset managers and leveraged funds in the week up to Aug. 27, Commodity Futures Trading Commission data shows. Continued unwind of net duration longs by asset managers saw the liquidation to the equivalent of around 435,000 10-year note futures equivalents. Hedge funds took the other side of the trade and covered approximately 670,000 10-year note futures in net short positioning across the strip.

Related: Asset Managers Unwind Treasury Futures Long at Record Pace: CFTC

Riskies Back to Neutral

The premium paid to hedge the market has remained close to neutral over the past week across tenors, after spiking a couple of weeks ago to favor call premium as traders looked for a continued market rally. Recent flows in Treasury options have included a buyer of 10-year puts, targeting a yield of around 4% by Sept. 20 and paying a premium of $7 million on the position.

--With assistance from Liz Capo McCormick and Ye Xie.