Bond traders reduced their exposure to futures and cash Treasuries last week, adopting a more neutral stance as the uncertainty surrounding tariffs clouded the economic outlook, Federal Reserve policy, and threatened to increase market volatility.
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alt text: A graph showing market trends.
This shift towards neutrality was evident in the Treasury futures market on Monday, where traders unwound positions across shorter maturities at the highest rate since November, reacting to President Trump’s impending tariffs. The open interest in two-year Treasury contracts has fallen to just over 4.1 million, the lowest level observed since June. Simultaneously, a recent JPMorgan Chase & Co. client survey reveals a significant decline in net long positions in cash Treasuries, retreating from near 15-year highs.
The beginning of this week underscored the risks associated with maintaining substantial positions in the face of tariff deadlines. In anticipation of US tariffs taking effect on Tuesday, short-dated Treasury yields spiked while longer-term yields declined. This indicated investor concern that the tariffs would accelerate inflation and hinder economic growth. However, much of this movement reversed when the president agreed to postpone tariffs on Mexico and Canada, leading to a two-day decline in US yields starting Wednesday.
“Navigating the current economic landscape requires extreme caution. It’s crucial to carefully consider the rationale behind any investment decision before committing capital,” advises Ed Al-Hussainy, a rates strategist at Columbia Threadneedle Investment. “Many investors have become more neutral on duration, preferring to avoid the heightened volatility.”
Hedging Strategies and Market Implications
The ongoing tariff situation has left traders hedging against various potential outcomes related to the upcoming Federal Reserve policy meeting in March. Options linked to the Secured Overnight Financing Rate (SOFR), a key indicator of the central bank’s policy trajectory, saw a surge in both dovish and hawkish hedging activity on Monday in anticipation of the March 19 rate announcement.
Currently, swaps rates are pricing in a mere three basis points of easing leading into the meeting, implying a slightly higher than 10% probability of a rate cut. This aligns with recent signals from policymakers suggesting a cautious approach to further rate reductions as they assess the impact of the new administration’s policies. However, significant activity surrounding April SOFR options contracts suggests that traders anticipate potential shifts in the market outlook in the coming weeks.
alt text: A chart depicting market volatility.
As of 8:50 a.m. in London, the yield on 10-year US Treasury notes decreased by two basis points to 4.49%, while the two-year yield, more responsive to monetary policy adjustments, remained relatively stable around 4.21%.
Key Positioning Indicators in the Rates Market
Several indicators provide insights into current market positioning:
JPMorgan Treasury Client Survey: The week ending February 3 witnessed a dramatic shift in client positioning, with outright shorts surging by 10 percentage points, the most significant increase since 2019. Long positions simultaneously plummeted, resulting in the smallest net-long position since December.
Treasury Options Premium: Options hedging in Treasuries currently reveals a substantial divergence between the long end of the curve, where traders are paying a substantial premium to hedge against a sell-off, and the front end and belly, where the premium is closer to neutral. This configuration supports the steepening trend observed during part of Monday’s session, as the long end underperformed. Notable flows on Monday included a large Week 1 option in long-bond notes, targeting a 30-year yield increase to approximately 4.88% from the current level of around 4.75%.
Most Active SOFR Options: Significant new risk has been added to the 96.0625 strike in SOFR options extending to the September 2025 tenor over the past week. Recent flows include a buyer of the June 2025 96.0625/96.1875/96.375 broken call fly. The 95.625 strike has also seen substantial new risk accumulation following last week’s flows, including a buyer of the June 2025 95.625/95.50 put spread.
SOFR Options Heatmap: The 96.00 strike remains the most populated in SOFR options out to the September 2025 tenor, primarily due to a high volume of March 2025 calls and June 2025 puts at that level. Increased activity has also been observed at the 95.875 strike, with recent flows including a buyer of the September 2025 95.875/95.625/95.375 put fly structure. Recent flows around the 96.00 strike have involved outright buying at a level of 11 ticks for new risk.
CFTC Futures Positioning: CFTC data through January 28 indicates that hedge funds aggressively increased their net short duration across the US futures strip by a combined 251,000 10-year note futures equivalents. Conversely, asset managers added approximately 146,000 10-year note futures equivalents to their net duration long positions. The most significant positioning shifts occurred in 10-year note futures, where hedge funds extended their net short position by $13.3 million/DV01, and in SOFR futures, where $5.3 million/DV01 was added to the net short position.
In conclusion, the prevailing uncertainty surrounding tariffs has prompted bond traders to adopt a more neutral stance, reducing their exposure to both futures and cash Treasuries. Market participants are actively hedging against various potential outcomes related to the upcoming Federal Reserve meeting, reflecting the complex interplay between trade policy, economic growth, and monetary policy expectations.
