Bond Traders Are Betting on Fed Rate Cuts Spilling Into 2027

gzsyrfdeppj9bcntqb4n(haz_media_dl_2.png Bloomberg, CME

Article content

(Bloomberg) — Traders in US futures and options markets are piling on bets that the Federal Reserve will continue cutting rates into next year instead of raising them.   

Article content

Futures spreads linked to the Secured Overnight Financing Rate, which closely track expected Fed policy, are becoming deeply inverted — a sign that traders are starting to price a more prolonged central bank easing cycle.  

Article content

Article content

Article content

Until recently, traders had been wagering that the central bank would resume hiking rates in 2027 after two quarter-point reductions by the end of this year. But a growing debate around the impact of artificial intelligence on the labor market is leading them to reassess this outlook. On Tuesday, Federal Reserve Governor Lisa Cook warned that the central bank may not be able to counter rising unemployment driven by the adoption of AI. 

Article content

Article content

The flattening move in SOFR spreads has accelerated since the end of last week, just as AI disruption fears took a toll on a swath of stocks, setting off a rally in long-dated Treasuries.

Article content

“The question is how is AI going to be inflationary and maybe the long end of the curve is sniffing all of this out,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “The only inflationary aspect of AI is the building out of data centers and the associated energy needs, and that is known.”

Article content

The 12-month December 2026 to 2027 SOFR spread dropped into negative on Friday with the inversion deepening on Tuesday to minus 8 basis points, in a sign that investors have flipped from pricing hikes in 2027 to pricing cuts. A record amount of just over 150,000 traded in the 12-month spread over Monday’s session. 

Article content

Article content

In the SOFR options market, a similar dovish theme is emerging in trades that are favoring hedging the prospect of multiple rate cuts this year. Those trades picked-up again on Tuesday with one position that’s looking to hedge for the policy rate falling to as low as 2% by the end of the year growing in size. Open interest in the December 98.00 calls ballooned to more than 400,000 this week. The swaps market is currently pricing a Fed rate of around 3.1% — or just over two 25-basis point cuts — by year-end, some 110 basis points above the options strike price.

Article content

SOFR Trade Targeting 2% Year-End Rate Surges to $40 Million

Article content

“There has certainly been a bit of repricing for lower yields after the Fed hits terminal,” said Gennadiy Goldberg, head of US rates strategy at TD Securities, with the market “penciling in a more gradual drift higher in yields.” 

Article content

“That could be driven by uncertainty regarding the impact of AI on the labor market, but fluctuations in longer-dated Fed expectations tend to be quite significant, making it difficult to read into them,” he said.

Article content

Treasury curve metrics also reflect the market’s pricing of prolonged rate cuts. The 2- to 5-year spread reached flattest levels since the start of December on Monday, while the richening of the 2s5s30s butterfly was the biggest one day move seen in six months, driven by outperformance in the belly of the curve.