The FOMC held policy in a 9-3 vote, with dissents from Hammack, Logan and Kashkari, while Chair Warsh also backed no change despite recent emphasis on price stability. Warsh said real rates rose between meetings because markets took cues from data rather than forward guidance, though the commentary pointed instead to a response to his “regime shift” language, followed by a reassessment of confidence in the Chair’s ability to deliver price stability. Market pricing for cumulative hikes eased from 56bp to 50bp, and the implied probability of a September move fell from near-certain to 65%.
The UST curve steepened most sharply since late March in 2s10s terms as long-end inflation expectations increased, with the 10y inflation swap a little above 2.3%. The base case outlined remained for 25bp hikes at the December and March meetings. The Fed left balance sheet policy unchanged, with task force results due by year-end, and the New York Fed continues reserve management purchases of T-bills at USD10bn per month.
Positioning for Continued Curve Steepening and Long-End Yield Upside
With the 2s10s Treasury yield curve experiencing its sharpest steepening since late March, we recommend that derivative traders position for continued curve steepening in the coming weeks. Since long-end inflation expectations have crept up to 2.3% on 10-year inflation swaps, traders can look to short long-term Treasury futures or enter into payer swaps to benefit from rising long-end yields. This steepening trend is highly relevant now as the market processes the Fed’s recent decision and adjusts to the reality of higher-for-longer long-term yields.
Short-Term Rate Derivative Opportunities and Volatility Strategies
Given that the market has scaled back the implied probability of a September rate hike from near-certainty to just 65%, we see a strong tactical opportunity in short-term interest rate derivatives. Because we expect robust AI-related capital spending and a tight labor market to keep inflation sticky, we believe the market is currently underpricing the Fed’s hawkish resolve. Buying put options on Secured Overnight Financing Rate (SOFR) futures expiring in September and December will help traders profit if the Fed is forced to tighten sooner than the market now expects.
With the Fed maintaining its steady Treasury bill purchase pace of $10 billion per month, short-term liquidity should remain highly stable through the autumn. Derivative traders can exploit this environment by selling short-dated volatility on front-end interest rates while waiting for the year-end balance sheet task force results. We believe targeting range-bound options strategies on short-term interest rates will yield the most consistent returns while the broader market remains divided on the Fed’s next move.
