Traders Prepare for Fewer Fed Rate Hikes with SOFR Options

In the wake of recent Federal Reserve actions, traders in the options market are adjusting their strategies to protect against the possibility that the central bank will raise interest rates less aggressively than current market forecasts suggest. Interest-rate swaps now imply expectations for three quarter-point increases by next June, a consensus that solidified after the Fed’s latest rate hike and its signals that additional increases remain necessary to control inflation.

This outlook has prompted a noticeable shift among investors seeking to manage risk through options linked to the Secured Overnight Financing Rate (SOFR), a benchmark highly sensitive to monetary policy changes. Over the past week, there has been a surge in demand for call options tied to March 2027 SOFR futures, indicating a growing desire to hedge against a scenario where the Fed’s tightening cycle is shallower than presently priced in.

Christian Hoffmann, who leads fixed income at Thornburg Investment Management, expressed a contrarian view, suggesting that the market’s expectation of three hikes may be overstated. He noted, "Four hikes over the course of a year is a pretty dramatic response to the economic backdrop and would have real reverberations through the macro economy." This sentiment reflects concerns that aggressive rate increases could weigh heavily on economic growth.

Energy prices, particularly oil, remain a significant factor influencing the Fed’s trajectory and market dynamics. The recent escalation in crude prices linked to conflict in Iran has contributed to a spike in U.S. long-term Treasury yields, which recently surpassed 5 percent. This volatility was mirrored on Tuesday as Treasury prices fluctuated alongside oil markets amid developments such as Saudi Arabia’s efforts to restart flow through a crucial pipeline and diplomatic activity at the United Nations in New York, where discussions continue about reopening the Strait of Hormuz.

George Bory, chief investment strategist for fixed income at Allspring Global Investments, has responded to these market conditions by increasing his bullish stance in bonds. His approach aligns with broader trends seen in JPMorgan Chase & Co.’s latest investor survey, which revealed a rise in outright long positions in Treasuries to the highest level since November of the previous year.

Bory highlighted the impact of higher yields, elevated monetary policy, and rising oil prices as factors that collectively act like a tax on economic growth. He warned that such pressures could become more evident as the year progresses into the fourth quarter and potentially into 2027. Additionally, he pointed to the possibility that easing geopolitical tensions in the Middle East and a slowdown in spending on artificial intelligence could reduce the Fed’s need for further rate hikes.

Data from Monday shows that open interest in March 2027 SOFR call options stood at approximately 2.7 million contracts, about one million more than the equivalent put options for the same period. This suggests traders are positioning for a Fed policy path that is less steep than currently anticipated. Jeff Schuh, head of the interest rates desk at Constitution Capital, interpreted the flow as reflecting expectations of one or two cautious hikes remaining, followed by a period of relative stability.

Among the notable positions in these SOFR options is a bet on an overnight rate near 3 percent in March 2027, significantly below the current effective Fed rate of 3.88 percent. Achieving this would require the Fed to begin cutting rates early in 2027, a scenario that remains unlikely at present.

A closer look at the recent week’s positioning reveals several key trends. According to JPMorgan’s Treasury Client Survey covering the week ending September 21, investors increased their outright long positions by four percentage points—the highest since November—while reducing short positions by six points. In SOFR options, heavy buying activity occurred in March 2027 calls, especially around the 97.00 and 96.25 strike prices, driven largely by complex call spread trades.

There was also notable activity in December 2026 puts, particularly at the 95.4375 strike, where traders bought put condors, a strategy designed to capitalize on limited price movement while managing risk. The 97.00 strike for March 2027 calls has become the most heavily populated across December 2026, March 2027, and June 2027 contracts, reflecting intense interest at that level. Open interest remains elevated in the 96.50 strikes, supported by substantial December 2026 call positions.

In the Treasury options market, the skew—representing the premium paid to hedge against price moves—continues to favor puts on long-dated bonds, although the premium has declined somewhat compared to recent weeks. This suggests a reduction in the cost investors are willing to pay to protect against a selloff in long-term Treasuries. The skew for short- to intermediate-term maturities has stayed near neutral during the same period.

These developments illustrate how investors are actively adjusting their exposure to anticipated Fed actions amid a complex mix of economic signals, geopolitical risks, and market forces. As the Federal Reserve navigates inflation and growth concerns, the options market serves as a barometer for shifting expectations regarding the pace and scale of future rate changes.