Traders in U.S. futures and options markets are building substantial positions anticipating the Federal Reserve will continue cutting interest rates into next year, rather than resuming hikes. The spread on futures tied to the Secured Overnight Financing Rate, which closely tracks market expectations for Fed policy, has inverted significantly—indicating traders are pricing in a more prolonged central bank easing cycle. Until recently, market participants expected the Fed to deliver two 25-basis-point cuts by year-end before restarting rate increases in 2027. However, growing debate around artificial intelligence’s impact on the labor market is prompting a reassessment of that outlook. On Tuesday, Fed Governor Lisa Cook warned that the central bank may struggle to respond effectively if AI adoption leads to rising unemployment. The flattening of SOFR spreads accelerated starting late last week, coinciding with concerns over AI’s disruptive effects weighing on equities and boosting long-dated Treasury prices.

According to Jack McIntyre, Portfolio Manager at Brandywine Global Investment Management, the key question is how AI could drive inflation, with the long end of the yield curve potentially reflecting that outlook. He noted that the only inflationary aspect of AI may stem from data center construction and related energy demand, which is already known. The 12-month SOFR spread between December 2026 and December 2027 turned negative last Friday and deepened further to -8 basis points by Tuesday, signaling a shift in investor expectations from rate hikes in 2027 to cuts by that time. Trading volume for this 12-month spread hit a record of over 150,000 contracts on Monday. A similar dovish theme is emerging in SOFR options markets, where activity is tilted toward hedging the prospect of multiple rate cuts this year. Trading picked up again on Tuesday, including a growing position designed to hedge against the policy rate falling as low as 2% by year-end. Open interest in the December 98.00 call option surged this week to over 400,000 contracts. Swaps markets currently price the Fed’s year-end rate near 3.1%—implying just over two 25-bp cuts—about 110 basis points above the strike price of that option.

Gennadiy Goldberg, Head of U.S. Rates Strategy at TD Securities, observed that after the Fed reached its terminal rate, there has been some repricing toward lower yields, with markets expecting a more gradual upward path. He added that uncertainty around AI's effect on the labor market may be a factor, though long-term Fed expectations tend to be volatile and difficult to interpret clearly. Other segments of the Treasury yield curve also reflect market pricing for sustained easing. The spread between 2-year and 5-year notes reached its flattest level since early December, while the 2s5s30s butterfly spread steepened by the most in six months due to strong performance in the middle of the curve. Meanwhile, in the cash market, traders appear hesitant in positioning for Treasuries. J.P. Morgan’s latest client survey, covering the week ending February 23, showed the share of neutral investors at its highest level since late 2024.

Recent positioning indicators in rates markets include: - J.P. Morgan Survey: Client short positions fell 4 percentage points and long positions declined 2 percentage points for the week ending February 23. Pure short positions dropped to the lowest since December, while neutral positioning rose to the highest since December 2024. - SOFR Options: Changes in open interest for March, June, and September SOFR options over the past week reveal significant new risk concentrated in several September 2026 put options, largely due to substantial buying of the SFRU6 96.4375/96.3125/96.1875 put butterfly (targeting a 2.25–2.50% range). Considerable upside positioning was also seen via March call options, with the SFRH6 96.375/96.4375/96.50 call butterfly being a popular trade. Across expirations through September 2026, the most concentrated strike remains 96.375, where large open interest persists in March 2026 calls, March 2026 puts, and June 2026 puts. Recent activity near the top of the range includes demand for the SFRH6 96.375/96.4375/96.50 call butterfly and the SFRM6 96.5625/96.4375/96.375 1x3x2 put butterfly. - Treasury Options Skew: The premium paid to hedge Treasury risk has widened further, with calls costing more than puts, indicating traders are paying higher prices to hedge against bond market gains rather than losses. This skew is most pronounced at the long end, where 10-year and long-bond option skew measures show call popularity at multi-month highs.