Bets on Outsize Fed Cut Gain Steam as CPI Data Backs Doves

(Bloomberg) -- A largely benign US inflation report is bolstering the case for traders betting that the Federal Reserve will soon cut interest rates, with some seeing an increased possibility of an outsized reduction.

For weeks, investors have piled into swaps, options and outright Treasury longs to wager that subdued inflation will allow the Fed to lower borrowing costs in coming months. There’s some vindication for that view, with shorter-term Treasury yields dropping for a second day on Wednesday, while swaps traders lifted the odds of a September rate cut to more than 90%.

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Bets that the Fed will reduce rates by more than 25 basis points in September also gained traction, with traders adding some $2 million in premium on Tuesday to a position in the Secured Overnight Financing Rate (SOFR) that would benefit from such a move. In an interview, Treasury Secretary Scott Bessent suggested that the Fed ought to be open to a bigger, 50 basis-point cut next month.

The inflation report “was a bit stronger than we have seen over the prior few months, but lower than many have feared,” said Rick Rieder, chief investment officer of global fixed income at BlackRock, in a note. “As a result, we expect the Fed to begin cutting rates in September, and it could be justified cutting the Funds rate by 50 basis points.”

Tuesday’s report was far from an all-clear for the Fed. Though a tepid rise in the costs of goods tempered concerns about tariff-driven price pressures, underlying US inflation accelerated in July by the most since the start of the year.

With more than a month remaining until the central bank’s Sep. 16-17 meeting, Treasury bulls will also need to weather another major inflation report as well as key employment data.

“September is not a done deal,” Claudia Sahm, chief economist at New Century Advisors, said on Bloomberg TV. “We do not have the data that puts this one in the bag yet.”WATCH: Claudia Sahm, New Century Advisors chief economist and a Bloomberg Opinion columnist, says a Fed rate cut in September is likely but not “in the bag yet.”Source: Bloomberg

For now, however, bets on a dovish Fed are taking the spotlight. The options trade linked to SOFR September contracts — where premium now stands at roughly $5 million — could pay off as much as $40 million should they price in a 50 basis point rate cut for that month, Bloomberg calculations showed.

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Meanwhile in the cash market, investors unwound long positions in the build-up to the inflation data, shown by a survey of JPMorgan Treasury clients covering the week up to Aug. 11.WATCH: Jay Barry, JPMorgan’s head of global rates strategy, says the recent economic data may give the Federal Reserve room to cut rates in September.Source: Bloomberg

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

JPMorgan Treasury Client Survey

In the week to Aug. 11, JPMorgan Treasury clients cut long positions by five percentage points, shifting into neutral with short positions unchanged over the week. The outright long positioning was subsequently reduced to the smallest amount in two weeks.

Most Active SOFR Options

In SOFR options across Sep25, Dec25 and Mar26 tenors over the past week there has been a jump in demand for strikes 96.25 and 96.125 across both Sep25 and Dec25 calls as traders look to target additional rate cut premium to be priced into this year’s remaining Fed meetings. One recent flow has been a large buyer of SOFR Sep25 96.125/96.25 call spreads, targeting a half-point rate cut at the September policy meeting with the same structure also trading recently in the Dec25 tenor.

SOFR Options Heatmap

The 95.625 strike remains most popular across Sep25, Dec25 and Mar26 options, with a large amount of risk seen in the level via Sep25 puts and Dec25 puts. Other populated strikes include 95.75 and 95.875, where Sep25 puts are prominent. Recent activity around the 95.625 strike has been buying of the SFRZ5 95.875/95.75/95.625 put fly. The 95.75 strike has been used recently also via buying in SFRZ5 96.5625/96.6875 call spreads vs selling SFRZ5 95.875/95.75 put spreads.

Treasury Options Skew

Treasury options skew continues to trade close to neutral across the curve, with long-bond options edging back slightly to favor puts. Recent flows in Treasury options have included a position which targets a 10-year yield rise to approximately 4.33% ahead of Wednesday’s close, for a premium of just over $1 million.

CFTC Futures Positioning

In the week to Aug. 5, asset managers aggressively added to net long positions with particular focus on ultra-long bonds, where the bullish positioning was extended by approximately $7.6 million per basis point in risk. On the flip side, hedge funds extended net short in ultra-long bond futures by around $8.2 million per basis point.

(Updates levels in the second paragraph.)

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