Traders Pay to Hedge Against Deeper-Than-Expected Fed Easing

(Bloomberg) -- Some investors are paying up to hedge against the risk that the Federal Reserve will need to cut interest rates much more deeply than most expect this year.

There was a flurry of trades Wednesday in eurodollar options that stand to benefit if Chairman Jerome Powell and his colleagues end up implementing much more than the one or two quarter-point cuts that are currently being priced as a central scenario for 2020.

Powell reiterated in congressional testimony this week that policy remains appropriate. But traders on Wednesday bought out-of-the-money December and March eurodollar call options with a strike price of 99.50, according to people familiar with the matter who asked not to be identified because they’re not authorized to speak publicly.

Buyers of such contracts stand to benefit if policy makers make around three or more cuts and start dragging the Fed benchmark much closer to zero, down from its current level of 1.50% to 1.75%.

“It’s entirely possible Fed policy makers will cut this year sooner than what’s priced in, depending on how the data and financial conditions evolve, or to boost inflation if needed,” BMO Capital Markets strategist Jon Hill said via phone. The impact of the spreading Wuhan coronavirus is the biggest question mark at the moment, he said.

At least $20 million of premium was spent on positions around those strikes, with some buying outright and others transacting as part of call spreads, the people familiar said. The transaction followed buying on similar options on Monday.

The pricing of these options -- many of which are deeply out-of-the-money -- may indicate that they are a hedge for an underlying portfolio of securities rather than an outright bet on Fed policy path, although it was unclear exactly which investors were behind the positions. Preliminary data on Thursday showed open interest in the options jumped, indicating the trades were new bets, rather than adjustments to existing positions.

Greater demand for rate-cut protection was also seen earlier on Wednesday through various other call spreads and fly structures.

Fed funds futures currently show around 34 basis points of easing priced in by the end of December, with a quarter-point cut fully priced in for when the Fed meets in November. But some strategists, including those at Deutsche Bank and Credit Suisse, reckon the Fed could be forced to deliver a rate cut by July.

©2020 Bloomberg L.P.

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