When he says this line "a knavish speech sleeps in a foolish ear" he is telling Rosencrantz that his good advice has been lost on his "friend's" stupidity and desire to be in the good graces of the king.
The first one is the answer
I believe that your answer is the first option due to how late the crying is, and unlike in "The Tell-Tale Heart" where the heart is constant and represents the slow descent of madness, the cry of the cat only appears at the end.
The portion of the story where it shows the speaker's madness is actually his looking for and finding similarities in the second cat and wishing to kill it.
Hope this was helpful.
