Insights 
VT 
Federal Reserve Governor Christopher Waller stated that the decision to cut rates in July should be followed by policy adjustments driven by incoming data, assessed on a meeting-by-meeting basis.
He identified a tentative long-term Fed funds rate of around 3%, acknowledging uncertainty in this estimation, but noted that current long-term bond yields do not indicate particularly loose financial conditions.
Fed’s Balance Sheet Strategy
Regarding the Fed’s balance sheet, Waller expressed that there is no urgency to sell Fed-owned mortgage bonds, characterising it as a slow process with minimal enthusiasm for aggressive sales. He emphasised that market signals should dictate the extent of balance sheet reductions rather than predetermined goals.
Waller also addressed the role of stablecoins, seeing them as adding competition within the payment system without posing systemic risks. On potential future positions, he confirmed no contact from the Trump team about becoming the Fed chair. He valued internal disagreements among Fed officials as beneficial, while emphasising a collective dedication to preserving the independence of the central bank.
Based on the governor’s comments, we should treat a July rate cut as a near certainty. Market pricing reflects this, with CME FedWatch Tool data from mid-July showing an over 90% probability of a 25-basis-point reduction. This initial move appears fully priced into front-month interest rate futures.
His emphasis on incoming data for subsequent moves introduces significant uncertainty for policy later this year. While June’s Consumer Price Index cooled to 3.0% year-over-year, the labor market remains resilient, with the latest report showing 272,000 jobs added, complicating the inflation narrative. We believe this makes options that bet on volatility for the September and December meetings, which currently seem underpriced, an attractive strategy.
Market Volatility Index
The recent decline in the MOVE index, a measure of bond market volatility, to near two-year lows seems inconsistent with the official’s view of a meeting-by-meeting approach. This suggests the market is complacent about the path of rates beyond the summer. We see an opportunity in positioning for a repricing of volatility, as any surprising data point could cause sharp moves in the Treasury curve.
The acknowledgement of uncertainty around the long-term neutral rate, which he estimates near 3%, should make us cautious about long-dated interest rate positions. The 10-year Treasury yield has been trading in a volatile range between 4.2% and 4.7% for months, reflecting this very ambiguity. This suggests the terminal rate for this cutting cycle is far from settled.
His dovish stance on shrinking the balance sheet, particularly the slow pace of mortgage bond sales, should act as a supportive factor for risk assets. The Federal Reserve is clearly trying to avoid a repeat of the 2019 repo market stress that was partially blamed on an overly aggressive balance sheet reduction. This measured approach reduces the risk of a sudden tightening of financial conditions from quantitative tightening.
