BNY Markets says US inflation is being propelled by non-rate-sensitive parts of core PCE, which could cap the impact of further Federal Reserve tightening. The firm expects one additional rate rise at the Fed’s December 2026 meeting, while casting doubt on whether the full set of hikes priced by markets for 2027 will materialise, given the supply-driven nature of the shock and the risk of demand destruction.
The note argues that if tighter policy suppresses demand but leaves the prices driving services inflation largely untouched, the Fed may be forced to ease its stance next year. It also frames the current policy regime as partly about maintaining credibility on inflation control, rather than relying on rate moves alone to compress inflation, unless demand slows materially. Even if energy prices fall and deliver a positive supply shock, BNY adds that demand-led inflation pressures could still re-emerge.
Fed Rate Hikes Overestimated Due to Supply-Side Pressures
We believe the market is overestimating how many times the Federal Reserve will raise interest rates in 2027. While one final rate hike is likely in December 2026, current market pricing fails to realize that rate hikes cannot fix supply-side inflation. Derivative traders should use the coming weeks to position for a sudden shift in this hawkish outlook.
Recent economic data shows that core services inflation remains sticky at 3.5%, largely driven by sectors like healthcare and transportation which do not respond to high interest rates. Historically, using aggressive rate hikes to cure supply-driven inflation only leads to severe demand destruction, forcing central banks to pivot. We expect this dynamic will force the Fed to pause its tightening cycle much sooner than the market expects.
Derivative Strategies and Yield Curve Steepening for a Fed Pause
We recommend derivative traders buy June 2027 Secured Overnight Financing Rate (SOFR) call options to capitalize on this eventual pause. If the Fed stops hiking, short-term yields will fall quickly, which historically triggers a massive surge in the value of these options. This strategy allows us to benefit as the market begins to price out these unnecessary 2027 rate hikes.
We also suggest implementing yield curve steepener trades, specifically by buying two-year Treasury futures and selling ten-year contracts. The Treasury yield curve remains highly inverted, but a Fed pause will rapidly push two-year yields downward. This trade offers an excellent hedge against the economic slowdown that these supply shocks are likely to cause.
