Some traders hedge against Fed rate hikes being fewer than market expects

Traders are seeking protection against the possibility that the Federal Reserve's rate-hiking cycle may be less aggressive than current market pricing suggests.

Interest rate swaps currently reflect expectations of three 25-basis-point rate hikes by June next year. This view was reinforced last week after Fed policymakers voted to raise the federal funds rate target range by 25 basis points and signaled further tightening is needed to curb inflation.

At the same time, this hawkish consensus is prompting some traders to hedge their risks using options tied to the policy-sensitive Secured Overnight Financing Rate (SOFR). Over the past week, demand for call options linked to March SOFR futures has increased, signaling growing interest in protecting against a less aggressive Fed policy path.

Christian Hoffmann, head of fixed income at Thornburg Investment Management, said: "The market is currently pricing in three rate hikes from now. I would bet on the opposite direction." He added, "Four rate hikes in a year is a fairly aggressive response to the current economic backdrop and would have material knock-on effects on the macroeconomy."

Open interest has risen over the past week, indicating new hedging positions are being established.

Oil Prices Remain a Key Variable

Oil remains a critical factor, continuing to exert significant influence on the Fed's policy path and market outlook. Crude oil prices, driven higher by factors related to the Middle East conflict, recently pushed the yield on the 10-year U.S. Treasury note above 5%.

On Tuesday, U.S. Treasury prices moved in tandem with oil prices as Saudi Arabia sought to resume crude flows through a key pipeline, while investors focused on the annual gathering of diplomats at the United Nations in New York for clues on progress toward reopening the Strait of Hormuz.

George Bory, chief investment strategist for fixed income at Allspring Global Investments, said the recent market environment has prompted him to increase his bullish positioning in the bond market. He is not alone. JPMorgan's latest investor survey shows that direct long positioning among investors has increased, reaching its highest level since November last year.

"Higher yields, higher current monetary policy rates, and higher oil prices are essentially a tax on economic growth," Bory said. "As a result, some of these pressures may begin to show in the fourth quarter and possibly extend into next year." He added that an economic slowdown, easing tensions in the Middle East, and a cooling of AI-related spending could all lead to fewer rate hikes from the Fed.

SOFR Options Show Bullish Bias

As of Monday's close, open interest in SOFR call options expiring in March 2027 — representing new risk exposure — stood at approximately 2.7 million contracts. That is roughly 1 million contracts more than put options for the same maturity, indicating traders are more inclined to hedge for a Fed policy path that is more dovish than current market pricing.

Jeff Schuh, head of interest rate trading at Constitution Capital, said: "These flows could mean the Fed has one or two cautious rate hikes left, but after those hikes, the market may enter a period of relative range-trading."

Open interest in March 2027 SOFR call options is 60% higher than for put options.

Additionally, a prominent position target in March 2027 SOFR options is an overnight rate near 3%, well below the current effective federal funds rate of 3.88%. Achieving this target would require the Fed to begin a rapid rate-cutting cycle by early 2027, a scenario few currently expect.

Summary of Positioning Over the Past Week

JPMorgan U.S. Treasury Client Survey

• For the week ending September 21, direct long positioning among investors increased by 4 percentage points, reaching its highest level since November last year.
• Short positioning decreased by 6 percentage points.

SOFR Options Positioning

• In SOFR options for December 2026, March 2027, and June 2027, the March 2027 call options saw significant new risk exposure across multiple strike prices over the past week, including:
• 97.00 strike (increase of 94,262 contracts)
• 96.25 strike (increase of 102,713 contracts)
• This was primarily driven by large purchases of SFRH7 96.25/97.00 2x3 call spreads. Demand for similar structures also emerged via SOFR March 2027 96.75/97.75 2x3 call spreads.
• The most actively traded strike over the past week was 95.4375, driven by a surge in December 2026 put options, including flows into SFRZ6 95.9375/95.8125/95.4375/95.3125 put condors.

SOFR Options Open Interest

• Due to heavy trading volume in SOFR March 2027 97.00 call options, the 97.00 strike has become the highest open interest strike across the December 2026, March 2027, and June 2027 tenors.
• Open interest at the 96.50 strike also remains elevated, with a significant number of December 2026 call option positions still outstanding.

U.S. Treasury Options Skew

• In long-dated Treasury futures, the option premium paid to hedge against Treasury futures risk remains skewed toward puts, though it has moved closer to neutral compared to several weeks ago. This suggests the premium traders pay to hedge against a sell-off in the long-end yield curve is declining.
• Skew from the front end to the middle of the curve has remained near neutral levels over the past week.