Fed rate cut expectations change! SOFR trading shifts to hawkish, betting that the Fed will remain on hold all year.

Experienced traders focusing on the trading of options, a derivative product, are increasingly inclined to exclude the expectation of the Fed continuing to cut interest rates in 2026 and instead bet that the Fed will maintain rates throughout the year. If the Fed does indeed maintain the benchmark rate unchanged throughout the year as they anticipate, their bets will yield positive returns. Since the release of multiple labor market statistics in December, combined with the latest CPI showing a steady pace of inflation cooling in the US, traders' expectations for a Fed rate cut in 2026 have continued to cool. Mixed good and bad labor market data, including December non-farm payroll figures, suggest a slight warming of the US labor market at the end of the year, marginally strengthening the narrative of a "soft landing." Since last Friday, the theme of a "rate cut trade" has shown signs of weakness, as the latest US non-farm payroll data showed moderate job recovery and an unexpected decrease in the unemployment rate. This almost completely eliminates the possibility of the Fed announcing further rate cuts at its policy meeting this month, prompting an increasing number of interest rate futures market traders to significantly delay the timing of rate cuts in the coming months. Following the release of the December non-farm payroll and unemployment rate data, the "CME FedWatch Tool" shows that traders' bets on Fed rate cuts in 2026 have reduced from pricing in three rate cuts at the end of 2025 to two rate cuts, with traders generally predicting the first rate cut in June 2026 instead of the previously speculated March. However, the rate cut expectations of traders shown by the "CME FedWatch Tool" still exceed the median expectations of Fed officials in the FOMC dot plot, which suggests only one rate cut in 2026. Stabilizing labor market conditions and a slow cooling in inflation pace may lead the Fed to announce that they will not cut rates in 2025 after three consecutive cuts, significantly weakening the rationale for further rate cuts, especially in the macroeconomic background of inflation remaining above the Fed's 2% long-term target. According to the statistics released by the US Bureau of Labor Statistics last Friday, after significant downward revisions in employment data from the previous two months (especially October showing a reduction of over 100,000 jobs), non-farm payroll employment increased by 50,000 last month, just below the general economist expectation of a 60,000 increase. The unemployment rate unexpectedly improved, significantly decreasing from the revised 4.6% in November to 4.4%, surpassing the unanimous expectation of a 4.5% unemployment rate, reflecting a significant reduction in the number of unemployed directly. The CPI released by the US Bureau of Labor Statistics on Tuesday in December showed a steady cooling of core CPI, but it remains stubborn and insufficient to push the Fed towards a rate cut this month. In the US market, the multiple labor market statistics for December show that after a marked slowdown in hiring pace in 2025, the US labor market still has some growth momentum entering the new year, particularly these data significantly reinforce the "soft landing" narrative, showing a combination of "layoffs easing and hiring intentions picking up," essentially fitting the employment image required for an economic soft landing trajectory. According to the statistical data from Challenger, Gray & Christmas Inc., US businesses announced a decrease in layoffs last month while planning to increase hiring. Challenger's statistics show that US companies announced 35,553 job cuts in December, unexpectedly hitting the lowest level since July 2024 and significantly decreasing from the high levels of layoffs in the previous two months. Additionally, survey data shows that US employers plan to add nearly 10,500 jobs, significantly exceeding market expectations and reaching the highest level for any December since 2022. According to ADP Research data, which is similar to a "small non-farm payroll," it also indicates that the job market may have gained some moderate expansion momentum at the end of the year, as US companies added 41,000 jobs in December, rebounding from a significant decline the previous month. An indicator of service sector hiring expanded last month to its strongest level since February. The statistical data released by the US government last Thursday shows that US labor productivity accelerated to its strongest pace in two years in the third quarter, further indicating that the wave of AI-driven efficiency improvement led by ChatGPT's emergence is significantly curbing inflationary pressures from the wage side. At the same time, as of the week ending on January 3rd (including the New Year holiday), the number of initial claims for unemployment benefits in the US increased by 8,000 from the previous week, reaching 208,000, slightly lower than the market's general expectation of 210,000 and still far below the average level of initial claims for unemployment benefits last year, strengthening signs of labor market recovery. In conclusion, a series of labor market data for December shows that US companies recruited employees at a moderate pace with some momentum, combined with stable inflation cooling, indicating that the US economy entering 2026 still remains resilient and is likely to lay a significant foundation for a complete achievement of a "soft landing." This, in the eyes of Wall Street financial giants like Goldman Sachs and Morgan Stanley, signals that the macro narrative of a "soft landing" in the US economy is expected to significantly warm up in 2026 - that is, the growth rate of the US economy is expected to be faster than the market anticipates. "We are facing an increasingly unpredictable employment situation, followed by a stubborn inflation problem," said David Robin, a rate strategist at TJM Institutional Services LLC. "From the perspective of actual data, the probability that the Fed will keep rates unchanged until at least March has significantly increased, with each subsequent meeting pushing back the possibility of a rate cut, increasing the probability of the Fed maintaining rates unchanged." Even though the options market still shows a widespread expectation of a half-percentage point rate cut in 2026, recent options flow related to the Secured Overnight Financing Rate (SOFR) market reveals a more hawkish interest rate pricing story. Many traders now believe that the Fed will not cut rates in 2026 The SOFR options market sentiment has shifted significantly over the past few days, with a focus on the near-term Fed funds rate and the increasing probability that the next rate cut decision will be further delayed. SOFR options positions for longer-dated contracts are benefiting significantly from the prospect of the Fed maintaining rates unchanged throughout 2026. It is expected that the benchmark rate will remain in the current range of 3.5%-3.75% until the end of the year. Robin from TJM remarked in an interview, "Whether the market believes that the Fed will keep rates unchanged - whether the probability is 5%, 10%, or 20% - the cost of these trades is very low. If you are a disciplined risk manager, you would choose to believe in this pricing." Some Wall Street strategists are starting to adopt similar views. Following the release of the non-farm payroll data last Friday, economists and strategists from J.P. Morgan stated that they no longer predict further rate cuts by the Fed this year, but instead forecast rate hikes in 2027. A month ago, HSBC Securities predicted that the Fed would not adjust the benchmark rate until 2027. The latest research report from Goldman Sachs economists shows that the Wall Street financial giant predicts the Fed will cut rates by 25 basis points in June and September, significantly delaying the previous prediction of cuts in March and June. Morgan Stanley, on the other hand, has pushed back its expected timing for rate cuts by the Fed from January and April to June and September this year, expecting a 25 basis point cut each time. The firm emphasizes that the core logic behind rate cuts has shifted from "stabilizing employment" to "combating stubborn inflation," and policy actions need to wait for the complete impact of tariffs to show and for inflation to clearly return to the 2% target. The change in sentiment in the SOFR options market comes against the backdrop of the increasingly tense relationship between the Trump administration and Fed Chair Powell, with Powell revealing last Sunday that the US Department of Justice had initiated a criminal investigation against him, which he stated had clear political motivations. This move has reignited concerns in the market about the independence of central banks, prompting a backlash from global central bank systems, US investors, and legislators, who have all actively defended Powell. This has also cooled bullish sentiment in the US Treasury bond market. A survey conducted by J.P. Morgan on clients' position changes up to the week ending January 12th showed a 4-percentage-point increase in short positions and a 3-percentage-point increase in long positions. The result is the smallest net long position in the US Treasury bond market since October 2024, marking the largest scale of short positioning since October 6th last year. The table below shows the positioning of J.P. Morgan clients in the US Treasury bond market - the net long position was at its lowest level since October 2024. The following is an overview of the latest positioning indicators in the interest rate market: SOFR Options In the trading of SOFR options expiring in March, June, and September 2026, there has been a significant demand in the past week for hedging downside risks through March options. The 96.375 exercise price has seen plenty of active liquidities for downside protection, including buying SFRH6 96.375/96.3125 put spreads and SFRH6 96.43759/96.375/96.3125 put options structures. Other options with increasing liquidity include buying SFRM6 96.5625/96.50/96.4375 put option structures. A large establishment of put options and structural protection positions reflects a significant weakening of rate cut expectations. The options expiring in March 26 (Mar26) have been notably active in the past week, especially the exercise price at 96.375 has attracted a large number of put/hedge positions, indicating that these structural options are valuable in SOFR options strategy when betting that the short-term interest rate will either remain high or no longer decline, as the pricing of SOFR is highly correlated with the Fed's policy rate outlook. In the interest rate options market, the 96.375 level generally corresponds to an implied annual rate of about 3.625% in the market, and the significant buying of downside protection measures suggests that traders are generally looking to avoid a significant further decline in rates (i.e., avoiding a deeper Fed rate-cut process). Looking at the specific distribution of open SOFR contracts, the market is clearly hedging or speculating on a scenario where the Fed delays rate cuts or maintains the benchmark rate unchanged for the full year, highlighting how the market is pushing back the potential window for rate cuts, reinforced by the non-farm payroll data and inflation dynamics, strengthening the probability of no rate cuts this year. In the SOFR options' open contracts for September 26, 2026, the exercise price at 96.50 still holds the highest position in the risk exposure held by traders, with significant positions in the March and June options. Put options at 96.375 and 96.3125 continue to hold significant open contract exposures, while the exercise price at 96.75 also holds large amounts of call options for March and June. The risk concentration around the 96.50 exercise price in the SOFR options market currently reflects traders' preference for pricing scenarios where benchmark rates "remain in the current state, with a further postponement in the rate-cut pace." The highest trading volume of open contracts is centered around 96.50 (implying an interest rate of around 3.50%), spanning across the June and September expiries, indicating the market's expectation that the Fed is more likely to maintain rates in the current range for a longer period and push any rate cut expectations to later months or to lower probabilities. The active positions in call/put options across multiple expiries suggest that rates may fluctuate within the current range rather than sharply declining, with the latest structure of open SOFR contracts reflecting the same expectation of a more prolonged rate pause and a turning away from expectations of significant rate cuts this year, instead moving towards a more hawkish scenario of "maintaining the benchmark rates." Treasury Options Premium Over the past week, investors have preferred to hedge US Treasury bond risk premiums with a bias towards front-end to 10-year Treasury options, while maintaining near neutrality in long-term Treasury options. This slight shift reflects investors paying slightly higher premiums to hedge against rising bond prices in the 2-year, 5-year, and 10-year Treasury futures markets, rather than seeking downside protection or higher yields. This near neutrality in long-term Treasury options is in line with the current market expectation that the Fed may not significantly cut rates in 2026 - investors are hedging risks to a small extent, rather than heavily betting on rate cuts.