Bond traders have been increasing their bets on options and futures, believing that the Federal Reserve is about to signal that next year's rate cuts will be larger than the market expects.
In the early hours of Thursday Beijing time, a 25 basis point rate cut by the Fed is almost seen as a foregone conclusion, so the Fed's updated quarterly economic and interest rate forecasts will become the focus. In September, the median forecast of Fed officials regarding their policy path, known as the 'dot plot', showed a total rate cut of a full percentage point over the next two years.
However, as inflation continues to rise, Wall Street banks begin to anticipate that the Federal Reserve may reduce one rate cut next year, totaling a 75 basis points cut. Some predict that the Fed may only cut by 50 basis points, a level that is basically consistent with the pricing in the swap market.
But in terms of interest rate options, some traders bet that the market view is too hawkish, and the Federal Reserve will be closer to its September forecast: to cut rates by four times 25 basis points in 2025, thereby lowering the implied target federal funds rate to 3.375%.
These traders may be thinking about how potential signs of a weak labor market could boost bets on the Fed increasing easing, as well as the surge in U.S. Treasury bonds earlier this month due to data showing an unexpected rise in the unemployment rate.
In options highly sensitive to expectations of Federal Reserve policy, linked to the secured overnight financing rate, demand is mainly concentrated on dovish bets maturing early next year, targeting early 2026. If the Fed's policy forecast is more dovish than the market expects, these positions will benefit.
At the same time, traders are also increasing their positions in Federal Reserve fund futures. Open contracts maturing in February next year have set a historical record, with pricing closely related to the Fed's policy statements in December and January next year. Recently, the capital flow around these fund futures has been biased towards buying, indicating that new bets will benefit from a rate cut by the Fed in December, followed by additional easing in the next decision on January 29 next year.
Morgan Stanley suggested buying Federal Reserve fund contracts expiring in February next year this month, a recommendation that seems to have driven bullish activity. Strategists indicated that investors should prepare for a higher likelihood of a 25 basis point rate cut expected by the market on January 29 next year. Assuming the Fed fulfills its commitment this week, the probability of a rate cut next month is about 10%.
Article forwarded from: Jin Ten Data