"U.S. Treasury Bullish" Dovish Celebration: Mild Inflation Boosts SOFR Options Betting, September Rate Cut Probability Rises to 90%

According to the Zhitong Finance APP, a generally mild U.S. inflation report is reinforcing traders' positions that the Federal Reserve will soon cut interest rates. Some believe the possibility of a significant rate cut is increasing.

For weeks, investors have been betting that mild inflation will lead the Federal Reserve to lower borrowing costs in the coming months through swaps, options, and directly going long on U.S. Treasuries. This view was initially validated on Tuesday. Data showed that the U.S. July CPI rose 0.2% month-on-month, as expected, compared to a previous value of 0.3%; the July CPI rose 2.7% year-on-year, slightly below the expected 2.8%, and the previous value was 2.7%. The July core CPI rose 0.3% month-on-month, as expected, compared to a previous value of 0.2%; the July core CPI rose 3.1% year-on-year, above the expected 3% and the previous value of 2.9%.

After the release of the U.S. July CPI data, short-term U.S. Treasury yields fell, and swap traders raised the probability of a Fed rate cut in September to 90%. Notably, traders have also gained more attention for betting on the Fed cutting rates by more than 25 basis points in September. They added about $2 million in option premiums to positions linked to the Secured Overnight Financing Rate (SOFR), which would profit in the scenario of a rate cut exceeding 25 basis points in September.

Rick Rieder, Chief Investment Officer of BlackRock's Global Fixed Income Division, stated, "Today's inflation report is slightly higher than the levels of the past few months but lower than many feared. Therefore, we expect the Fed to start cutting rates in September, and a 50 basis point cut is also reasonable."

However, Tuesday's report did not lead the Fed to completely relax. While the mild rise in commodity prices eased market concerns about price pressures driven by tariffs, the growth rate of core inflation in the U.S. in July reached its highest level since the beginning of the year. With more than a month to go before the Fed's meeting on September 16-17, Treasury bulls still need to navigate another important inflation report and key employment data.

Claudia Sahm, Chief Economist at New Century Advisors, stated, "A rate cut in September is not a done deal. We do not yet have conclusive data to prove this."

However, the current market focus remains on betting on the Fed's dovish stance. According to media calculations, options trading linked to the September SOFR contract (with premiums currently around $5 million) could yield up to $40 million in returns if the market prices in a 50 basis point rate cut that month.

Meanwhile, in the spot market, investors had already reduced their long positions in U.S. Treasuries before the inflation data was released. JPMorgan's survey of U.S. Treasury clients for the week ending August 11 showed that long positions among its Treasury clients decreased by 5 percentage points, shifting to neutral, while short positions remained unchanged this week.

In the past week, there was a surge in demand for call options at strike prices of 96.25 and 96.125 for SOFR options expiring on September 25, December 25, and March 26, as traders sought to reflect further rate cut premiums in the remaining Federal Reserve meetings this year. A recent flow involved significant buying of the SOFR September 25 96.125/96.25 call spread, targeting a 50 basis point rate cut at the September policy meeting, with a similar structure also seen for the December 25 expiration.

The skew of U.S. Treasury options remains close to neutral across the term structure, with long-term bond options slightly retreating, leaning towards put options. Recent trading in U.S. Treasury options included a bet that the 10-year Treasury yield would rise to around 4.33% before Wednesday's close, with the option premium for this trade slightly above $1 million.