Bond Traders Are Set for Rally to Extend as CPI Test Looms

(Bloomberg) -- Bond traders who’ve endured some dramatic swings lately are betting on big gains heading into Wednesday’s key inflation report.

US Treasuries rallied sharply at the start of last week, sparked by broader market upheaval and mounting concerns that a softening economy may force aggressive Federal Reserve interest-rate cuts. Even after traders subsequently unwound some of their more extreme bullish positions, the tone remains firm, with the market “tactically and structurally still extended long,” according to Citigroup strategist David Bieber.

Open interest, or the amount of risk taken on by futures traders, has started to rise in some tenors over the past couple of sessions, consistent with fresh long positions after an aggressive period of liquidations across the Treasury curve. Meanwhile, in the cash market, JPMorgan Chase & Co.’s Treasury client survey released Tuesday showed net long positions among clients at their most since December. 

On Tuesday, US bonds advanced across the board after US data showed producer prices rose less than forecast in July, adding to evidence that inflation is under control enough to allow the Fed to start monetary easing next month. A report due Wednesday on consumer prices is expected to provide further support. 

“The market is leaning in a very dovish direction” and “anticipating soft inflation numbers which allow the Fed to begin to cut rates,” Matt Luzzetti chief US economist at Deutsche Bank told Bloomberg Television on Tuesday after the producer price report. 

In Treasury options, similar to the futures market, traders have retreated from extremes, though positioning suggests that expectations for lower yields remain intact. Based on so-called options skew, traders are betting on a better chance of a deeper bond market rally than a selloff in the days ahead. 

As for the Fed, the market is pricing in one full quarter-point rate cut in September, while also reflecting some wagers on a half-point reduction. 

Here’s a rundown of the latest positioning indicators across the rates market:

JPM Survey

In the week up to Aug. 12, JPMorgan’s Treasury client survey showed a short position reduction of 5 percentage points, shifting into neutral as long positions remained unchanged. The move subsequently pushed the client net long holdings to the most since December. 

Risk Is Off Extremes

The cost of hedging for the chance of a bond market rally has edged lower after the premium on calls touched the highest since March 2020. The move has coincided with the trend higher in Treasury yields as calm has returned to markets. The 10-year US yield, for example, is at 3.86%, up from as low as 3.665% Aug. 5. 

Half-Point Cut Hedges Remain

Over the past week, the biggest amount of open interest gains in options out to the March 2025 tenor was seen in the 95.3125 strike, boosted by a large position add in the Sep24 tenor. This comes via aggressive buying of the SFRU4 95.1875/95.3125/95.4375 call fly, which has been bought in around 80,000 size over the last week. The position looks to target a half-point Fed cut to be priced into the September policy meeting.    

SOFR Options Heatmap

In SOFR options out to the March 2025 tenor, the 94.875 strike remains the heaviest amount of open interest, due to large positions being added via Sep24 calls and puts along with Dec24 put options. 

Asset Managers Extend Duration Longs

Coming out of the July jobs report, asset managers extended their net duration longs by an equivalent of roughly 150,000 10-year note futures, CFTC data up to Aug. 6 showed. Asset manager net duration long is now just short of 9 million 10-year note futures across the curve, a record amount. Hedge funds took the other side over the week, extending net short positions by approximately 200,000 10-year note futures equivalents, with net short positions in 10-year note futures moving to a fresh record amount. 

--With assistance from Michael Mackenzie.

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