After the Fed Holds Rates Steady, Rate Hike Bets Unwind Quickly; Open Interest in August Fed Funds Futures Drops Sharply

According to Zhitong Finance APP, after the Federal Reserve announced that it would keep interest rates unchanged, a large number of trades that had previously bet on a rate hike in July were quickly reversed, and large-scale short positions built around August federal funds futures began to be closed out en masse.

Market data shows that the highly-watched open interest in August federal funds futures briefly exceeded 1 million contracts for the first time before the Fed's policy meeting, involving a notional value of about $5 trillion. This reflects the high level of divergence among investors regarding the interest rate outlook ahead of July's policy meeting. This was also the second monetary policy meeting since the new Fed Chair, Walsh, took office.

David Robin, Managing Director and Rate Strategist at TJM LLC, noted that the market had previously generally believed the Fed needed to raise rates to maintain policy credibility, which led to the establishment of a large number of interest rate hike positions. Walsh had sent signals in several public statements that there would be "no action in July," including emphasizing the need for more economic data as the basis for decision-making. As a result, the market's massive bets on a July hike ultimately proved to be mistaken.

Robin stated that after the Fed announced it would keep rates between 3.5% and 3.75%, it took less than five seconds for August federal funds futures prices to adjust rapidly, causing large short positions betting on rate hikes to suffer losses.

Data released by the Chicago Mercantile Exchange on Thursday showed that open interest in August federal funds futures decreased by about 140,000 contracts from the previous trading day, indicating that a significant number of short positions had been closed out or stopped out.

Since the August contract expires before the next Fed meeting on September 16, shorting this contract was essentially betting on a rate hike at the July meeting. Just before the rate decision was announced, the interest rate swaps market priced in a roughly one-third probability of a July rate hike, with implied hike expectations peaking at about 12.5 basis points—almost a 50-50 chance. However, after the Fed held steady, implied hike expectations quickly dropped to around 7 basis points, sending August federal funds futures prices sharply higher and turning previous short positions from profits to losses.

Data from the US Commodity Futures Trading Commission (CFTC) shows that since May, leveraged funds have continuously increased their short positions on federal funds futures, rising to the highest level in about a year. Meanwhile, market makers have steadily increased their long positions, taking the opposite side of the leveraged funds’ trades.

The most notable trade in the market occurred on June 16, the day before Walsh chaired his first monetary policy meeting. On that day, a large block sale of 50,000 August federal funds futures contracts was executed at a price of 96.350. Each basis point moves the P&L by approximately $2.1 million. If this position had been held until this week's policy meeting, it would have shown a floating profit of about $10 million just before the announcement, but after the Fed held rates steady, it flipped to a loss of about $3 million by Wednesday’s close.

Additionally, just before Wednesday's policy meeting, about 20,000 short trades in August federal funds futures were executed at prices between 96.295 and 96.290. If these positions were not closed in time, the one-day loss would have been roughly $6 million. Due to the anonymous nature of futures market trading, it is impossible for outsiders to confirm the exact trading institution or the ultimate beneficiary.

Although Thursday's trading volume for August federal funds futures remained fairly high at around 215,000 contracts, it was significantly lower than Wednesday's record 728,000 contracts, when a large number of positions were closed, driving volumes sharply higher. By comparison, the average volume for the contract over the past 15 trading days stood at about 318,000 contracts.

Alan Taylor, founding partner of Archr LLP, said that when the market had initially priced in only about 3 basis points of hike expectations, building corresponding hedging positions was highly cost-effective; but as hike expectations gradually rose to around 9 basis points, the risk of holding these positions increased significantly.

Taylor noted that given the large scale of positions, it is reasonable to establish protective trades early when hedging costs are low. However, as hike expectations continued to rise, some investors began to scale back their positions, while the market has never truly believed the probability of a July hike would exceed 50%.