Rate cut expectations are resurging! U.S. bond traders are no longer betting on inflation, but instead are betting that oil prices will drag down the economy.

With the escalation of tensions in the Middle East pushing oil prices to multi-year highs, the trading logic in the US bond market is undergoing a fundamental shift. Traders are abandoning their bets on rising inflation, focusing instead on the impact that high energy prices could have on the US and global economic growth. This change in sentiment is particularly stark in the interest rate markets: just last week, futures prices were confidently predicting a rate hike by the Federal Reserve before the end of the year; now, expectations reflected in the interest rate swaps market have completely reversed - the cumulative amount of rate cuts by the Federal Reserve by the end of 2026 is approximately 6 basis points, implying a probability of about 25% of a rate cut by the Federal Reserve by the end of the year. Ian Lyngen, head of US rate strategy at BMO Capital Markets, pointed out that investors now generally believe that the threat posed by energy shocks to global economic growth is on par with, if not more severe than, inflation fears. This dramatic shift in view is quickly evident in the options market linked to the Secured Overnight Financing Rate (SOFR). Monday's data showed a clear signal of a change in the size of open positions: the hawkish positions that were hedging against rate hikes have been closed out, resulting in losses. On Tuesday, there was a notable trade in the market, where a strategy involved selling put options to generate funds, aiming to profit from the ongoing shift from a dovish stance to a more neutral stance in the front end of the interest rate curve. The "CME FedWatch Tool" indicates that market participants are currently pricing in a 25 basis point rate cut at the December Federal Reserve policy meeting. This change in strategy reflects investors' reassessment of the economic impact of the Iran conflict. Early market interpretations suggested that the Federal Reserve would have to raise rates to curb an expected rebound in inflation, but concerns about economic growth have now taken precedence, driving a rally in US Treasuries and other major sovereign bonds. Federal Reserve Chairman Jerome Powell's remarks on Monday further solidified this market consensus, indicating that the central bank is inclined to overlook the impact of rising oil prices and not adjust interest rate policy accordingly. In the middle of the treasury yield curve, there is also a noticeable reallocation of funds. On Monday, as the price of 5-year Treasury futures rose, open interest increased rather than decreased. This sends a key message - the rise is not being driven by short covering (a price rise typically accompanied by a decrease in open interest due to short positions being bought back), but by new long positions entering the market. This suggests that investors are not being forced to stop losses, but are actively entering bullish positions. It is understood that this sector has experienced a prolonged period of deleveraging (investors reducing positions, lowering risk exposure), and now this behavior is reversing, with a return of demand for "bottom fishing" or "re-entering long positions." Additionally, the spot market is also showing bullish momentum, with a Morgan Stanley survey released on Tuesday showing that client net long positions in bonds have reached their highest level since November of last year. Here is an overview of the latest position indicators in the interest rate market: Morgan Stanley Client Survey For the week ending March 30, Morgan Stanley client long positions increased by 2 percentage points, while short and neutral positions each decreased by 1 percentage point, resulting in the largest net long position since November of last year. SOFR Options The microstructure of the SOFR options market further confirms this pricing shift. Over the past week, traders have been building new risk exposures on put options expiring in June and December 2026 with a strike price of 96.00 to hedge potential rate hike risks. Recent fund flows around this strike price include buying the 96.3125/96.00 put spread combination for June 2026 and selling the 96.25/96.00/95.75 put tree structure. The 96.25 strike price has also been active in the past week, with a notable trade involving selling 25,000 lots of straddle options expiring in September 2026, with premium payments reaching as high as $30 million. In terms of strike price distribution, the 96.50 strike price remains the most concentrated in the June, September, and December 2026 contracts, accumulating a large number of call and put option risks expiring in June, as well as call options expiring in December. It is worth noting that the June SOFR options will expire on June 12, a week before the policy statement on June 17. Additionally, the volume of open positions near the 96.4375 strike price for June options has significantly increased recently, with trades including buying the 96.4375/96.50 call spread for June and selling 2Q September 97.375 call options, forming a steepening ratio bull steepening structure with a volume scale of approximately 100,000 lots to 50,000 lots. Treasury Options Premium The risk premium structure of the Treasury options market has also experienced significant adjustments. In recent weeks, the hedge premium for front-end options on the yield curve has been tilted towards put options, but has now fallen back to near neutral levels, reflecting the dovish repricing in the front end market on Friday and Monday, as well as the market's re-alignment of rate cut expectations from the end of this year to next year. However, at the long end of the curve, the option premium still leans towards put options, indicating that traders are more willing to pay insurance costs for selling long-term bond futures rather than buying them. Market participants are closely watching these developments and adjusting their strategies accordingly as the US bond market undergoes a significant shift in response to the changing economic landscape.