The recent US CPI report aligned largely with expectations, showing minimal tariff impact on inflation. While tariffs have affected prices, the impact is less than anticipated, months after initial reciprocal tariffs were introduced.
Consequently, traders are nearly unanimous, with ~98% believing in a 25 basis points rate cut next month, slightly up from ~89% prior to the inflation data. For the entire year, they forecast ~60 basis points of rate cuts, showing minimal change from ~57 basis points before. Traders were already anticipating a rate cut following weak US jobs data, and this seems to solidify that expectation for September.
Divergent Views Among Policymakers
Divergence exists among Fed policymakers regarding their views on rate cuts. Kansas City Fed president Schmid opposed a September cut despite inflation figures. Richmond Fed president Barkin remained neutral, mentioning unclear balance between inflation and unemployment. Politicisation within the Fed is intensifying, with some members influenced by political appointees.
The upcoming Fed meeting on 17 September coincides with various economic events, including the Jackson Hole symposium and labour market and CPI reports. This timeline provides limited opportunity for policymakers to influence market perceptions, especially with potential rising price pressures flagged by UBS and Goldman Sachs.
With the market now pricing in a 98% chance of a rate cut next month, the simple trade is already done. We saw a similar setup in 2024 where the market consistently front-ran the Fed, only for the cuts to be delayed. The real opportunity now lies in trading the potential for a surprise, not in following the herd.
Given the almost certain pricing, volatility is cheap, which presents an opportunity. We should consider buying some cheap protection against a hawkish surprise from the Fed at Jackson Hole later this month. Out-of-the-money puts on Treasury futures or even calls on the VIX could pay off handsomely if policymakers push back hard against market expectations.
Opportunities in the Yield Curve
The most direct play on the rate cut itself is now in the yield curve. We can structure a steepener trade, which profits if short-term rates fall more than long-term rates. This can be done by buying 2-year note futures (/ZT) while selling 10-year note futures (/ZN), a position that benefits from the cut but also if future inflation fears push long-term yields higher.
For equities, a cut driven by economic weakness, like the recent jobs report that showed a gain of only 95,000 jobs, isn’t a clear signal to go all-in. While rate-sensitive sectors like technology and real estate should get a lift, we should use defined-risk strategies like call spreads. This allows us to participate in the upside while capping our risk if the weak economy drags down earnings.
The dissent from voting members like Schmid and warnings from banks about future inflation shouldn’t be ignored. The next CPI report on September 11th will be released during the Fed’s blackout period, meaning they cannot guide the market’s reaction. If that report comes in hot, it could create significant turmoil and rapidly unwind the current dovish pricing.
