JP Morgan suggests that the Federal Reserve’s current policy is excessively restrictive, given the economy’s mixed signals. The firm believes there is a case for initiating a rate-cut cycle. However, it also suggests that the Fed is unlikely to cut rates aggressively due to tight labour markets, wage growth, and overall consumer resilience.
The firm comments on the state of the markets, noting the strength of the Magnificent 7’s earnings. Despite this, it anticipates a gradual shift towards a more inclusive S&P 500, with anticipated earnings growth synchronising between big tech and other sectors by 2026. The strains on low- and middle-income households are acknowledged, while higher earners are noted to be sustaining much of the economic momentum. The strategist implies that while rate cuts are justified, the Federal Reserve should proceed with caution.
Interest Rate Outlook
The Federal Reserve’s current policy seems too restrictive given the mixed economic signals we are seeing. This supports the view that a cycle of interest rate cuts is justified and on the horizon. For derivative traders, this outlook favors positioning for gradually falling interest rates in the coming weeks and months.
However, we don’t expect the Fed to act aggressively, as the August 2025 jobs report showed a solid 190,000 jobs added and core inflation remains sticky near 3.5%. This cautious stance suggests that while long positions in Treasury futures are logical, they carry risk. A more prudent strategy might involve using options, such as buying call spreads on bond ETFs like TLT, to limit downside if the Fed waits longer than expected.
In the stock market, the earnings power of the Magnificent 7 stocks continues to provide support for major indices. Year-to-date through August 2025, the performance gap remains stark, with the top seven tech stocks returning over 35% compared to just 8% for the other 493 companies in the S&P 500. This is a pattern we saw intensify throughout 2023 and 2024.
Market Positioning
This leadership concentration suggests a rotation into the broader market is a growing possibility as we look toward 2026. A way to position for this is to maintain a bullish outlook on the S&P 500 using SPY calls while simultaneously buying protective puts on a tech-heavy index like the QQQ. This captures general market upside while hedging against a pullback in the most crowded part of the market.
Given the uncertainty over the exact timing of Fed cuts, we do not expect a collapse in market volatility. This environment, similar to the choppy conditions we experienced in early 2024 before the Fed’s pivot was confirmed, could keep the VIX index from falling to its historical lows. Selling short-dated, out-of-the-money options on indices could be an effective way to generate income from this expected stability.
