Some Bonds traders have been increasing bets on Options and Futures, anticipating that the Fed will signal a larger reduction in interest rates next year than the market expects.

Ahead of the Fed's policy decision in the afternoon, US Treasury bonds rose modestly on Wednesday. With a 25 basis point rate cut from the Fed seen as almost certain, the market's focus is on the Fed's latest quarterly forecast. The dot plot released in September indicated that officials expect to cut rates by a total of 100 basis points over the next two years.

However, given that inflation data shows stickiness, the overall market bets that the Fed will lower its forecast for rate cuts next year, with swap rates indicating that the Fed will only cut rates by 50 basis points.

But in the realm of interest rate Options, some traders are betting that market views are too hawkish and believe the Fed will come closer to its September forecast of cutting rates four times in 2025, each by 25 basis points, pushing the implied federal funds rate down to 3.375%.

These traders may consider that signs of a weak labor market could bolster bets for the Fed to increase rate cuts, as well as the rise in US Treasury bonds following an unexpected increase in unemployment earlier this month. The rise in US Treasury bonds was later reversed, with the yield on 10-year Treasury bonds having risen about 20 basis points this month to around 4.4%.

Michael Rottmann and other economists and strategists at Unicredit wrote in a report that a dovish dot plot would be "a surprise and should end the recent steady rise in yields," adding that if Fed Chairman Jerome Powell takes a hawkish tone during the press conference, the rally may be interrupted.

In Options tied to the Secured Overnight Financing Rate (SOFR), demand is primarily focused on dovish bets on contracts expiring early next year aimed at early 2026. If the Fed's policy forecasts are more dovish than the market expects, these positions will benefit.

At the same time, traders are increasing their positions in Federal Funds Futures. The open interest for February, which is closely tied to the Federal Reserve's policy statements in December and January, has risen to record highs. The recent capital flows have favored the Bid, indicating that the latest bets will benefit from a rate cut in December and a further cut on January 29.

Call activity seems to be boosted by Morgan Stanley's Buy recommendation on February Federal Funds Rate contracts this month. Strategists suggest that investors should prepare for the rise in the market's implied probability of a 25 basis points rate cut at the FOMC meeting on January 29. Assuming the Federal Reserve acts as expected on Wednesday, the current market prices in approximately a 10% possibility of a 25 basis points rate cut next month.