Interest rate futures inversion warning: Traders bet on "continued rate cuts" replacing "rate hikes next year," why did market expectations for the Federal Reserve suddenly change overnight?

Bloomberg News has learned that traders in the U.S. futures and options markets are heavily betting that the Federal Reserve will continue to cut interest rates into next year, rather than resuming rate hikes.

The futures spread linked to the secured overnight financing rate (which closely tracks market expectations of Fed policy) is becoming deeply inverted—marking that traders are beginning to price in a more prolonged easing cycle by the central bank.

Until recently, traders still bet that after two 25 basis point rate cuts by the end of this year, the Fed would resume hikes in 2027. However, discussions about AI’s impact on the labor market are intensifying, prompting them to reassess this outlook. On Tuesday, Fed Governor Lisa Cook warned that the central bank might be powerless to respond to rising unemployment caused by the proliferation of AI applications.

Since late last week, the flattening of the SOFR spread has accelerated, coinciding with concerns over AI’s disruptive effects weighing on stocks and triggering a rally in long-term U.S. Treasuries.

“The issue is how AI will trigger inflation, and perhaps the long end of the yield curve is sensing all of this,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “The only way AI might cause inflation is through data center construction and related energy demand, and that’s well known.”

The 12-month SOFR spread from December 2026 to December 2027 fell into negative territory last Friday, and by Tuesday, the inversion deepened to -8 basis points, indicating investor expectations have shifted from rate hikes in 2027 to pricing in cuts by then. During Monday’s trading session, the volume of the 12-month spread contracts hit a record of over 150,000.

In the SOFR options market, similar dovish themes are emerging, with trading favoring hedges against multiple rate cuts this year. These trades were active again on Tuesday, including a position that has been expanding to hedge the possibility of policy rates falling to as low as 2% by year-end. Open interest in December 98.00 calls has surged to over 400,000 contracts this week. Currently, the swap market prices the Fed’s year-end rate at about 3.1%—just slightly above the two 25 basis point cuts—about 110 basis points above the strike price of these options.

“After the Fed hits its terminal rate, there are definitely signs of the market re-pricing to lower yields,” said Gennadi Goldber, head of U.S. interest rate strategy at TD Securities. “Expectations for yields will rise more gradually and smoothly.”

He added that this may be due to uncertainty about AI’s impact on the labor market, but long-term expectations for the Fed tend to be quite volatile, making it difficult to draw firm conclusions.

Indicators in the Treasury yield curve also reflect market pricing for continued rate cuts. The 2- to 5-year Treasury spread reached its flattest level since early December on Monday, while the 2s5s30s butterfly steepened to its largest single-day move in six months, driven by strong performance in the mid-curve.

Meanwhile, in the cash market, traders appear uncertain about how to position in Treasuries. A recent client survey by JPMorgan as of the week ending February 23 shows the highest proportion of neutral positions since late 2024.

Here are the latest interest rate market positioning indicators:

JPMorgan Survey

During the week ending February 23, clients reduced their short positions by 4 percentage points and their long positions by 2 percentage points. Pure short positions fell to their lowest since December, while neutral holdings rose to their highest since December 2024.

SOFR Options

Over the past week, open interest changes in March, June, and September SOFR options show a large influx of risk concentrated in several September 2026 put options, mainly due to heavy buying of SFRU6 96.4375/96.3125/96.1875 put butterfly spreads (price range 2.25 to 2.5) last Thursday. Also, there was notable upside betting in March calls, with SFRH6 96.375/96.4375/96.50 calls being a popular choice.

Overall, as of September 26, the most active strike prices for options are centered around 96.375, with substantial open interest in March 2026 calls, puts, and June 2026 puts. Recent trading around the top strike includes demand for SFRH6 96.375/96.4375/96.50 call spreads and SFRM6 96.5625/96.4375/96.375 put butterfly spreads.

U.S. Treasury Options Premiums

The premiums paid to hedge Treasury risks have further widened, with calls costing more than puts, indicating traders are paying higher prices to hedge against rising bond markets rather than falling. This skew is most pronounced at the long end of the curve, with the 10-year and long-term bond options’ skew indicators reaching their highest levels in months.