Short sellers have aggressively built bearish positions in the Treasury market before the Federal Reserve's rate decision on Wednesday, betting that the selloff that drove yields to decade-plus highs will extend further. As traders brace for a potential Fed rate increase to tackle inflation concerns, the benchmark 10-year Treasury yield climbed to its highest level since 2007 on Tuesday, while the 2-year yield reached its strongest point for the year.

Positioning data indicates investors anticipate additional weakness in bonds, with limited appetite to buy on dips. A weekly survey by JPMorgan of Treasury clients revealed that cash-market traders added to bearish bets at the quickest pace since early 2025 over the past week. Meanwhile, open-interest figures from CME Group show that investors also increased short positions in Treasury futures around the release of last week's hotter-than-expected inflation report. In the federal funds futures market, one large bearish block trade stood to gain or lose $1.9 million for every basis-point move in the underlying contracts.

Swap markets currently price in roughly 50 basis points of Fed tightening for the remainder of the year, including a move at the September meeting. "Short positioning has built up rapidly over the past week as the market followed yields higher," said David Bieber, a strategist at Citigroup, adding that the current short positioning is "extreme from a tactical standpoint."

The bearish market setup coincides with the Fed's upcoming rate decision. Wall Street now sees a greater than 90% probability that the central bank will implement its first rate increase since 2023 this week, marking the highest conviction level in decades—and historical patterns show that when market pricing reaches such certainty, the outcome has consistently matched expectations. Rising oil prices driven by geopolitical conflict, signs of resurgent inflation, and budget concerns have all reinforced this outlook.

Jason Thomas, head of global research and investment strategy at Carlyle, said in an interview that the Fed faces "tremendous pressure" to hike rates by 25 basis points. Should the central bank hold steady—or even if it raises rates without signaling further tightening—traders could demand higher yields on long-dated Treasuries to hedge against inflation risk, while short-term yields might decline.

Some market participants have already positioned for that scenario. In Tuesday's short-rate options trading, demand surged for cheap October and November secured overnight financing rate (SOFR) futures call options, which are also highly sensitive to monetary policy expectations. However, this remains a minority view for now, as the broader SOFR options market is skewed toward hedging against the risk of more rate-hike premium being priced into near-term contracts in the coming months.

All eyes now turn to the Fed's decision, with the extreme bearish positioning setting the stage for a potentially volatile market reaction either way.