Federal Reserve Chair Powell recently addressed the National Association for Business Economics, indicating an unchanged economic outlook since September. The Fed reduced interest rates by 25 basis points then, addressing risks to the labour market, driven mainly by supply side issues.

The ‘dot plot’ suggests a median of two additional interest rate cuts this year, although a majority anticipated no further reductions. Nonetheless, market expectations align with efforts to update the Fed’s base case, implying cuts in both October and December. The prediction includes a continued reduction of 75 basis points over the next year at a pace of 25 basis points quarterly, resulting in a Fed funds rate upper bound of 3.00% by September 2026.

Policy Outlook and Inflation Risks

The existing policy is perceived as less restrictive than the Federal Open Market Committee believes, increasing the likelihood of inflation risks due to frontloaded easing. Despite AI-boom being less sensitive to interest rates, it is becoming more debt-financed and could grow with lower rates. Concurrent fiscal easing next year may compound demand-driven inflation increases. Tariff-induced inflation will also contribute, potentially affecting future Fed predictions. Updated inflation and growth forecasts will be released in the upcoming Global Outlook.

With the Federal Reserve signaling rate cuts for both this month and December, the immediate path for policy seems clear. The latest jobs report for September 2025 showed a cooling labor market, with payrolls adding just 150,000 and unemployment ticking up to 4.1%, giving the Fed its justification. Traders should therefore maintain positions that benefit from falling short-term interest rates in the weeks ahead.

Given that the market has already fully priced in these two 25 basis point cuts, the most straightforward trades in Fed Funds or SOFR futures may offer limited upside. Instead, traders could explore options strategies that profit from this high degree of certainty. For example, selling out-of-the-money puts on short-term rate futures could be a way to collect premium as the market waits for the Fed to deliver on its expected cuts.

However, we believe the primary risk is that the Fed is making a policy error by focusing on the labor market while ignoring inflation. The Consumer Price Index report for September 2025 came in hotter than anticipated at 3.8%, with core inflation remaining sticky just above 4%. This mirrors the dynamic we saw back in 2021, where the Fed initially overlooked rising inflation that later required aggressive tightening.

Strategies for Potential Market Scenarios

This front-loaded easing cycle is happening just as an AI-driven investment boom is becoming more reliant on debt, which will only be spurred by lower rates. Recent industry analysis shows corporate debt issuance for AI infrastructure is up 30% from this time last year. This, combined with upcoming fiscal stimulus, is creating a powerful tailwind for demand-driven inflation.

This outlook suggests a yield curve steepening trade could be profitable. This involves using derivatives to bet on long-term rates rising due to inflation fears even as the Fed cuts short-term rates. A strategy of going long 10-year Treasury note futures while shorting 2-year futures would directly benefit from this divergence.

For a longer-term perspective, traders should consider buying derivatives that would pay off if the Fed is forced to abruptly reverse its policy in 2026. Purchasing call options on SOFR futures for mid-2026 delivery is a relatively cheap way to hedge against this risk. This positions for the possibility that the current path of easing will ultimately create an inflation problem that requires a much more aggressive response down the line.

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