On the eve of the annual Jackson Hole meeting, traders are heavily betting that the Fed will cut rates by 50 basis points next month.
Although the U.S. July PPI released last week recorded the largest month-over-month increase in three years, traders' bets on a 50 basis point rate cut have not diminished at all. On Tuesday, U.S. Treasuries ended three consecutive days of selling, with yields declining across the board, indicating that the market still tends to believe that the Federal Reserve will take action next month.
Data show that options contracts betting on a 50 basis point rate cut in September reached 325,000, with a premium cost of about $10 million. If the Fed cuts rates by 50 basis points as expected, these positions could profit up to $100 million.
Powell's key speech at the annual meeting on Friday will directly validate or overturn market expectations for monetary easing. Currently, traders are pricing in about an 80% probability of a 25 basis point rate cut by the Fed in September.
Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets, pointed out in a report that:
As the market prepares for Powell's speech, we believe the biggest risk facing U.S. Treasuries is that the Fed chair chooses to pour cold water on the widely anticipated September rate cut.
Market sentiment shifts, and shorts fall to a monthly low.
Beyond aggressive options betting, broader market sentiment also shows a shift in investor positions. J.P. Morgan's latest U.S. Treasury client survey shows that investors are moving from short positions to neutral positions.
According to data for the week ending August 18, J.P. Morgan clients' direct short positions fell by 4 percentage points and shifted to neutral positions. The current percentages of direct short and neutral positions are at their lowest and highest levels since July 14, respectively. This indicates that before Powell's speech, overall bearish sentiment in the market is weakening.
However, this widespread dovish expectation also lays the groundwork for risks. Ian Lyngen warns that:
It is noteworthy that if Powell does not exhibit the dovish stance currently expected by the market, the front end of the yield curve may easily be impacted by a bearish correction.
Institutional investors are diversifying their positions, focusing on long-end allocations.
According to CFTC data, in the week ending August 12, asset managers increased their net long positions in most bond futures, especially in long-term and ultra-long-term bonds. Meanwhile, hedge funds increased their net short positions in 10-year U.S. Treasury futures while reducing their short positions in long-term Treasury futures.
In addition, the skew indicator for U.S. Treasury options also sends mixed signals. The options skew for long-term bonds tends to favor put options, indicating that traders are willing to pay higher premiums to hedge against the sell-off in long-term bond futures.
However, the skew of options from the front end to the mid-term slightly favors call options, suggesting that traders are hedging for a rebound in this part of the curve. This overall reflects the market's demand for steepening the yield curve through options positioning.
