Traders Hedge Against "Emergency" Fed Hike as Middle East Conflict Intensifies
There are growing signs that bond traders are increasingly unnerved by the prospect of a further escalation in the Iran conflict, amidst continued U.S. military reinforcement in the Middle East and stubbornly high oil prices. Some traders are now attempting to hedge against "worst-case" war consequences—a scenario that could force the Federal Reserve to hike interest rates within the coming weeks.
In the interest-rate options market tracking Fed policy, demand emerged this week for bets tied to the Secured Overnight Financing Rate (SOFR) that align with expectations of an "emergency rate hike" as soon as two weeks from now.
In other words, these positions stand to profit if the bond market significantly upwardly revises its hike expectations before the Fed’s next policy meeting on April 29. This rapid surge in demand for emergency-hike hedging marks a sharp reversal in market sentiment:
Just one month ago, market participants anticipated three 25-basis-point cuts by year-end. But since the outbreak of hostilities on February 28, swap traders have priced the probability of a hike by December at approximately 50%, leaving short-term Treasuries vulnerable to further re-pricing risk.
It should be noted that the interest-rate swap market currently prices in only a 3-basis-point move for the Fed’s April meeting—representing roughly a 12% probability of a 25-basis-point hike.
Jeff Schuh, Head of Rates Trading at Constitution Capital, stated that while the latest options bets do not reflect the consensus baseline, they indicate rising concern that rapid inflation will jeopardize investors who have been long on Treasuries in recent months.
As concerns over a resurgence of inflation triggered by surging oil prices mount, traders have recently liquidated large volumes of long positions in U.S. interest-rate futures. Schuh noted that the sell-off in SOFR futures and the broad-based rise in yields across the curve are catching large funds off-guard.
Schuh described these latest hedging trades as a low-cost risk management tool, calling them a "cheap remedy" for funds seeking to manage interest-rate risk, which "makes the risk of blowouts look more manageable in 90% of cases."
This demand for emergency-hike hedging is clearly driven by contradictory signals surrounding negotiations between the U.S. and Iran to end hostilities.
On Thursday, Iran rejected a U.S. ceasefire plan and presented its own conditions; meanwhile, although President Trump delayed planned strikes on Iranian energy facilities by 10 days, Defense Department officials revealed that the Pentagon is considering deploying up to 10,000 additional ground troops to the Middle East.
This has left traders facing unprecedented uncertainty regarding the Fed's policy outlook. Chicago Fed President Austan Goolsbee signaled earlier this month that the Fed may need to tighten policy given the impact of oil prices on the U.S. economy. Analysts at BofA Securities also recently noted that even if a ceasefire is reached, the Fed may still lean toward a rate hike if energy prices do not quickly retreat to pre-war levels and WTI crude remains sustained above $80 per barrel.