Hawks expect a warming trend as traders increase their bets on "higher for longer" and reduce the magnitude of interest rate cuts for next year and beyond.

According to Dolphin Research APP, options traders are seeking protection ahead of the Federal Reserve's interest rate decision on Wednesday, local time, in case rates continue to rise.

This is different from the norm in the past few weeks, where traders have generally hedged against a turning point in rate cuts in mid-2024. This change in momentum comes against the backdrop of reduced expectations for loose policies next year, with the market widely expecting the Fed to raise rates again in November or December and maintain them at high levels indefinitely.

In Wednesday's policy statement, policymakers will also update economic forecasts, including policy rates. The market believes that the dot plot is expected to show another rate hike before the end of the year. In futures related to the Secured Overnight Financing Rate (SOFR), the "Higher for longer" trading theme has seen a significant breakthrough recently. Last Friday, trading volume related to this theme reached a historic high.

Meanwhile, the latest U.S. Treasury client survey released by JPMorgan on Tuesday showed that investor net long positions rose to the highest level in a month.

Here is an overview of positions in various market sectors:

New SOFR options risk

This week, there have been several large-scale bullish trades in the March 2024 SOFR options. Unfilled contracts after Monday's trading implied that bullish hedging has brought new risks, mainly concentrated in early next year. In terms of SOFR futures, demand for the steepening trade on December 23/March 24 surged last Friday, benefiting from the Fed's "Higher for longer" decision.

Fading rate cut expectations

The overnight index swap (OIS) market corresponding to the Fed meeting has reduced the magnitude of rate cuts expected for next year and beyond. As shown in the chart, compared to September 1, the September 19 swap market shows a 37 basis point increase in year-end rates for 2024.

Leveraged funds and asset management companies reducing positions

According to data from the U.S. Commodity Futures Trading Commission (CFTC) as of the week ending September 12, hedge funds reduced their overall net short positions in the equivalent of about 38,000 10-year Treasury futures contracts, while asset management companies reduced their overall net long positions in the equivalent of about 51,000 10-year Treasury futures contracts. However, the net short position of leveraged funds remains high, far exceeding the position equivalent to 6 million 10-year government bond futures contracts.

Summary of block trades

In the week ending September 18th, the trading activity of 5-year government bond futures continued to rise, with block trading volume far exceeding that of any other tenor government bonds.

Sell-off of long-term US Treasury bonds leads to rising hedging costs

The latest changes in the skewness of bond futures options indicate that the hedging costs for selling long-term bonds are rising compared to the front and belly of the yield curve. As US Treasury yields rose on Tuesday, the 10-year bond yield surpassed the high point in August, reaching the highest level since 2007.