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Bond Market Rally Anticipated as Traders Brace for Inflation Data


Benjamin Hughes

May 14, 2024 - 20:55 pm


Bond Market Braces for Inflation Data Amid Hopes of a Rally

Amidst a volatile financial landscape, traders of U.S. Treasury options are hedging their predictions in favor of a bond rally following the anticipated release of critical inflation data later this week. There has been a significant increase in buying options that would profit from a descent in U.S. 10-year yields to about 4.3%, a level unseen in over a month and 15 basis points beneath the current rate. In the melee of bets, one high-stakes gamble shines through: a potential $15 million reward from a mere $150,000 bet if the 10-year yield dips further to 4.25% by May 24.

Bonds Recover Ground After Tough April

The bond rally speculation arrived on the heels of a rough April, where soaring yields and plummeting bond prices depicted a harsh environment for investors. However, this bearish trend saw a reversal with rates now stabilizing due to some degree, and investors increasingly expecting the Federal Reserve to ease on interest hikes. Federal Reserve Chair Jerome Powell assuaged market fears with comments alluding to less aggressive rate activity. Further optimism bloomed following recent labor market data that hinted at a slowing momentum which could potentially pave the way for interest rate cuts.

Expectations are now highly set on the forthcoming U.S. consumer price data for April, which is poised to play a pivotal role in either reinforcing or derailing the budding bond rally. In a similar vein, advancing Treasuries prior to the release basked in a report which gave somewhat of a "mixed" perspective on the last month’s wholesale prices—a development Powell highlighted in his remarks.

Prevalent Market Sentiment Leans Towards Easing

According to Alex Manzara, a derivatives broker at R.J. O’Brien & Associates, the recent trajectory of market positioning has largely leaned towards the possibility of an easing on the Federal Reserve's part, potentially an aggressive one. This trend reveals a market gripped by the possibility of adverse economic shifts that could trigger rapid policy easing.

CME Group data underlines that open interest, indicating the volume of new positions, has notably surged in options related to the 110.00 call strike, which corresponds with approximately a 4.3% yield for the 10-year Treasury. This uptick centered predominantly in the June options, which expire on May 24, thus encapsulating the week’s significant financial updates, including producer and consumer price reports.

On another optimistic note, asset managers have been amplifying their long positions in futures for a consecutive fourth week, as seen in the data from the Commodity Futures Trading Commission (CFTC).

A Diverse Range of Bets Across the Market

Despite the bullish sentiment, caution remains noticeable within certain market sectors. A slight increment in short positions in the cash market for Treasuries was observed in a JPMorgan Chase & Co.’s client survey, transitioning from a neutral stance. It's essential to remember that the last three reports on consumer prices have brought surprises that defy bullish assumptions.

Yet in the futures sphere, sentiment has decidedly swung less bearish post the release of the latest employment data. Traders are easing out of bearish futures positions tied to the SOFR (Secured Overnight Financing Rate), thereby scrapping hedges against possible rate increases and reviving easing bets. Additionally, new long positions have begun to manifest across various futures tenors. The result is a moderation from the deep-seated bearish outlook recorded at the end of April.

Citigroup analyst Ed Acton noted in a recent communication that, despite the substantial rise in long tactical positioning, the market's overall positioning still presents a mixed view, offering few clues on directionality. It showcases a longer tactical positioning against a structurally bearish backdrop.

Noteworthy Options Trades Signal Bullish Sentiment

Notable in the options segment is the prevalence of large bullish strategies known as "screen trades," executed electronically. One trade, in particular, had a premium of $4 million and translated into new risk on the books. This protection bet was repeated over the course of the early hours in Tuesday’s Asian session. The market also witnessed substantial buying in risk-reversal option strategies, which involve purchasing puts while concurrently selling calls.

Latest Positioning Indicators

Asset Manager Duration Bump

In the week following up to May 7, which encapsulated the Fed's policy announcement and the payroll report for May, asset managers increased their net long positions in duration, marking the fourth consecutive week of such an increment. These additions were significantly observed in the long-bond futures, amassing $2.5 million per basis point in net long positions. On the opposite side, hedge funds extended their net short positions by about 200,000 10-year note futures for that week. There was a considerable addition of net shorts in the five-year tenor, amounting to approximately $7.7 million per basis point.

JPMorgan Survey Shorts Rise

The overall sentiment in the cash market leaned slightly more towards bearishness, with short positions reaching a two-week peak. The latest JPMorgan survey of Treasury clients documents this shift, recording the stance leading up to May 13.

Treasury Skew Neutral

In recent developments, the cost to hedge against a Treasury selloff along the longer end of the curve has been diminishing, retreating from what used to be a heightened premium for put options about a month ago. At present, the skew in both the front end and the belly of the curve maintains a slight preference for rally hedging premiums, with the 10-year note tenor marking a relatively neutral stance. The past week has seen bright signs of upside protection on 10-year note futures, along with significant "strangle" flows, including a 4-to-1 seller trade observed on Monday.

Emergence of SOFR Options Activity

In the realm of SOFR options trading, the 94.6875 strike emerged as the most active over the recent week. This activity has been spurred on by significant market moves such as the sale of the Dec24 94.6875/94.4375 put spread and the buying of the Jun24 94.6875/94.75/94.8125 call fly. Boosts in the 94.875 strike have been upheld by purchasing the Sep24 94.875 straddle and the Jun24 94.75/94.8125/94.875 call fly.

SOFR Options Heat Map

Open interest has sharply risen in the Dec24 96.00 and 97.00 SOFR calls, as positions have built substantially up to approximately 185,000 in the SFRZ4 96.00/97.00 call spread. This position was bought again at 5.5 in quantities of 15,000 on Monday, indicating new risk. As for the most populated SOFR options strike extending to the Dec24 tenor, it is currently the 95.50 strike, bringing to light a large amount of open interest evident in the Jun24 calls. The outcomes of the upcoming Fed policy announcement and May CPI data, both due on June 14, are keenly anticipated and are likely to influence the options expiring on June 24.

Bloomberg CME

The convoluted picture painted by the various indicators sheds light on a bond market teetering on the cusp of change, and it is now in the hands of forthcoming consumer price index reports to steer the trajectory.

This news article contains insights received from Elizabeth Stanton's assistance and derives its analysis from Bloomberg L.P. For more information on the current state of the bond market and to peruse the full range of financial data, readers are encouraged to visit Bloomberg's official site at Bloomberg L.P..