Bond traders are panicking due to the possibility of further escalation in the Iran conflict, seeking to hedge against the worst-case outcomes of war—that is, the Federal Reserve may be forced to raise interest rates in the coming weeks.
In the options market tracking the Federal Reserve's policy, demand for bets linked to the Secured Overnight Financing Rate (SOFR) has emerged, corresponding to scenarios where interest rates may be raised as early as within two weeks. If the bond market significantly raises interest rate expectations before the Federal Reserve policy meeting on April 29, these trades will profit.
This surge in hedging demand for emergency rate hikes marks a dramatic reversal in market sentiment. Just a month ago, the market anticipated at most three rate cuts of 25 basis points by the end of this year. Since the outbreak of war on February 28, swap market traders have begun to price in about a 50% probability of a rate hike before December, which poses a risk of further repricing for short-term U.S. Treasuries.
Jeff Schuh, head of the interest rate department at Constitution Capital, stated that while the latest bets do not reflect the benchmark scenario of the market, they do indicate growing concerns: the rapid rise in inflation will pose risks to investors who have been long on US Treasuries in recent months.
Schuh stated that as oil prices soar, raising concerns about inflation again, traders have closed out a large number of long positions in US Treasury futures. The sell-off of SOFR futures and the rise across the entire yield curve of US Treasuries have caught many large funds off guard. He pointed out that for funds seeking to manage interest rate risk, such trades "in 90% of cases make the risk of a margin call appear more controllable, serving as a cheap stopgap measure."
Currently, the interest rate swap market only accounts for a 3 basis point increase at the policy meeting on April 29, meaning the probability of a 25 basis point hike is 12%.
The contradictory signals released by both the US and Iran regarding the end of hostile actions have further increased the hedging demand. On Thursday, Iran stated it had rejected the US proposal to end the war and presented its own conditions; President Trump announced an extension of the previously set five-day deadline for reaching an agreement by 10 days.
This has forced traders to deal with unprecedented uncertainty regarding the Fed's policy outlook. Meanwhile, Kevin Warsh is set to take over as Chairman of the Fed this summer, replacing Jerome Powell, while Trump continues to pressure for lower interest rates.
Schuh stated: "Even though Warsh is set to take over soon, there is significant uncertainty regarding the interest rate trend. It remains to be seen how long it will take for him to reach a consensus or a 'majority' in the board to push for rate cuts."
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