Source: Finance Association

Although the latest pricing in the interest rate swap market shows that current traders expect the Fed to cut interest rates by a total of about 40 basis points before the end of this year, which means the possibility of cutting interest rates by 25 basis points twice is slightly greater, in the options market, some bold investors are betting that the Fed may not drop interest rates even once this year, and there is even no shortage of risks of restarting interest rate hikes.

As the US economy continues to perform strongly, while progress in falling inflation has stalled, Fed policymakers have recently been sending hawkish signals that they expect to maintain higher interest rates for a longer period of time, and this has had a ripple effect on various market hedging derivatives instruments...

Before the US Federal Reserve's May interest rate meeting next week, many traders have already established options positions linked to the Guaranteed Overnight Financing Interest Rate (SOFR). The goal is to bet that the Fed officials will keep interest rates unchanged at the current high level after the December policy meeting.

Some more aggressive bets also hedge against the possibility that the Federal Reserve will even raise interest rates again in 2024.

However, regardless of the above situation, it is actually more extreme than the consensus reflected in the swap market.

The possibility of interest rate hikes is rising

Columbia Threadneedle Investments interest rate strategist Ed Al-Hussainy said earlier this week that options pricing reflects a 20% chance of interest rate hikes this year. His analysis was based on options that would be paid in the event of an increase in SOFR (the money market benchmark that closely tracks the Federal Reserve's borrowing costs).

Benson Durham, head of global policy and asset allocation at Piper Sandler, also pointed out that his analysis shows that the possibility of interest rate hikes in the next 12 months is close to 25%, while Prudential Investment Management (PGIM)'s analysis of Barclays options data shows that the probability of raising interest rates within the same period is as high as 29%.

In fact, with the Federal Reserve's “Big Three” and New York Federal Reserve Chairman Williams first discussed the possibility of the Fed's interest rate hike in his speech before the silence period last week, it is clear that this risk is no longer like a “fantasy” at the beginning of the year.

Williams said at the time that another rate hike was not his basic prediction. But he also added, “If the data reminds us that we need to raise interest rates to achieve our goals, then we obviously want to do that.”

Richard Clarida (Richard Clarida), a former vice chairman of the Federal Reserve and currently working as an economic advisor at Pacific Investment Management Company (PIMCO), also said, “At some point in the future, if the data continues to disappoint, then I think the Fed will have to start raising interest rates again. Although the rate hike is not my baseline forecast, it is possible to raise interest rates if the core inflation rate returns above 3%.”

On Tuesday, the most notable part of the US Treasury options deal was a $11 million bet aimed at raising the 10-year US Treasury yield to 5% within a month — the current yield level is around 4.6%.

There is still an opportunity to cut interest rates quickly

Of course, it should be pointed out that although investors are using options to hedge against the possibility of interest rate hikes or try to profit from them, there is still a possibility of a series of rapid interest rate cuts.

Durham believes that the options market shows that the probability that the Federal Reserve will cut borrowing costs by 200 basis points (that is, cut interest rates by 25 basis points eight times) within the next 12 months is about 20%.

“There is a lot of uncertainty. My baseline forecast is similar to the Fed's baseline forecast for the past 18 months, but I can also see the risk that they will cut interest rates faster under certain scenarios, or raise interest rates again for various reasons.” Durham said.

editor/tolk