Inflation cools to boost US bond market, traders accelerate closing positions on bets of Fed rate hikes.

After the consecutive release of moderate consumer price and producer price data in the United States, the sentiment in the US bond market has clearly turned optimistic, and interest rate option traders are accelerating the unwinding of positions previously established to guard against a rate hike by the Federal Reserve later this year. Market expectations for further tightening of monetary policy by the Fed have significantly cooled, and there is even a reassessment of whether a rate hike is still necessary this year. Despite a slight decline in US Treasury bonds on Thursday due to the impact of rising international oil prices and European bond yields, the options market linked to the secured overnight financing rate is still dominated by the selling of put options. SOFR usually moves in the same direction as the Fed policy rate, making related options an important tool for investors to bet on the interest rate path. Previously, traders hedged against the risk of short-term rate increases caused by a Fed rate hike by buying SOFR put options; now, with the cooling of rate hike expectations, many investors are selling these options to exit their positions. Christopher Hodge, Chief Economist at Natixis in the US, stated that the market is gradually realizing that a Fed rate hike is not a foregone conclusion. He pointed out that two consecutive inflation reports significantly below market expectations, as well as a more moderate inflation outlook, indicate that the current degree of monetary policy restriction may already be sufficient. The consumer price index (CPI) and producer price index (PPI) released in the US on Tuesday and Wednesday respectively both showed that inflation is cooling faster than economists expected. As a result, market assessments of the Fed's policy path quickly adjusted. Previously, investors had expected the Fed to hike rates twice by mid-2027, with each hike being 25 basis points, with at least one hike expected this year. Now, market expectations have shifted to the Fed possibly hiking rates only once, or even not at all. The interest rate swap market currently prices in a 4 basis point likelihood of a rate hike at the Fed's meeting on July 29, equivalent to a 16% probability of a 25 basis point hike. Earlier in the week, the probability of a rate hike in July was around 40%. At the same time, the cumulative rate hike reflected in December contracts is currently around 29 basis points, significantly down from 43 basis points at the beginning of the week. As rate hike expectations rapidly cool, the demand for related hedging tools has decreased, prompting traders to sell SOFR put options that they bought over the past few weeks. During the US trading session on Thursday, selling pressure continued to dominate for SOFR put options expiring in September and December. A similar trend was seen on Wednesday, with a decrease in open interest contracts, indicating that investors were mainly unwinding old positions rather than establishing new short positions. However, international oil prices remain a key variable influencing speculation on Fed policy. After the breakdown of the US-Iran ceasefire agreement, oil prices have risen again in the past week, raising concerns that a rebound in energy costs could once again drive up inflation. The rise in oil prices has somewhat offset the downward pressure on US Treasury yields from the moderate inflation data, and also suggests that the market has not completely ruled out the possibility of future Fed rate hikes. Overall, the latest inflation data has significantly reduced traders' bets on a rate hike this year, but energy prices and the situation in the Middle East could still cause rate expectations to change again.