Investors are Starting to Bet a Big Money on the Federal Reserve Increasing to 6%

Several large wagers on the central bank's benchmark rate reaching 6%, about a percentage point over the current consensus, have emerged this week in interest-rate options, indicating a shift in sentiment towards Federal Reserve policy.

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The reasoning behind them contradicts what has been an article of faith for the previous two months: that the Fed is nearing the conclusion of its tightening cycle after eight rate hikes in the past year. It is believed that interest rates are now high enough to precipitate a recession, requiring the central bank to change the direction this year.

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However, solid January employment statistics posted on Friday contradicted this theory, and remarks made by Fed officials this week further weakened it. Now, a halt after only one or two more rate rises does not appear so certain.

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This coming Tuesday, a trader acquired a substantial position in options that would yield $135 million if the central bank continues to tighten monetary policy until September. The purchase of the same structure resumed on Wednesday, concurrently with identical wagers stated in other forms.

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Preliminary open-interest data from the Chicago Mercantile Exchange verified Tuesday's $18 million wager on Secured Overnight Financing Rate options expected to expire in September, which targeted a benchmark rate of 6%. This is about one full percentage point over the 5.1% threshold for that month that is presently priced into interest-rate swaps.

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Buying of the position was continuous throughout Tuesday's session, but it accelerated dramatically in the afternoon via block trades after Fed Chair Jerome Powell indicated that the most recent monthly employment report may need a greater degree of tightening than previously expected. According to Trade Algo's estimates, the trade would break even at a policy rate of roughly 5.6% and generate $60 million if the Fed raised the rate to 5.8%.

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It is the latest in a string of large bets that show no signs of abating despite the Federal Reserve slowing down the tightening cycle that was the quickest since the early 1980s. Last month, SOFR options wagers had the largest inflows ever for any product traded on the CME Group platform.

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Before the strong employment data was released last week, the dominant theme on the market was substantial rate reduction in the second half of 2023.

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Overnight index swaps continue to be priced for easing later on in the year. Currently, they project that the Fed's benchmark rate would peak at around 5.17 percent in July before falling to approximately 4.84% by the end of 2023, meaning approximately 32 basis point decreases. However, this is a decrease from Thursday's closing, when 45 basis points were deducted. Now that markets are aligned with the most recent set of projections announced in December, investors are eagerly anticipating the publication of the central bank's so-called "dot plot" following its next policy meeting in March.

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Several officials spoke on Wednesday, including New York Fed President John Williams, who told Trade Algo that the December estimate "still appears to be a pretty fair perspective of what we'll need to do this year."

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According to Jason England, a global bond portfolio manager at Janus Henderson Investors in Corona Del Mar, California, whether this outlook persists until March will depend on the inflation statistics issued between now and then.

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"The market has returned to parity with the Fed's current peak, terminal interest rate. The concern is, "Do they alter the dots?" England stated.