Bloomberg WIRP pricing after the July US CPI release put the implied probability of a 25bp hike at the September FOMC at 39.9%, down from 48.1% on 11 August. The shift points to softer near-term expectations for further tightening in the federal funds target rate, even as markets continue to reprice around incoming inflation data.
UOB’s baseline scenario is for the Federal Reserve to keep policy on hold for the remainder of 2026, with easing restarting in 2027. The projected path assumes two 25bp cuts, one in late-2Q27 and another in late-4Q27, taking the federal funds rate to about 3.25% by end-2027, which is framed as the terminal rate estimate. The outlook also references geopolitical and energy-related uncertainty as factors that could keep the possibility of policy tightening in view.
Adjusting Short-Term Strategies Amidst Rate Stability
With the probability of near-term rate hikes dropping significantly following the July CPI print, we should immediately adjust our short-term derivative positions. We expect a prolonged period of interest rate stability, meaning Secured Overnight Financing Rate (SOFR) futures will likely trade in a very tight range. Traders should look to capitalize on this quiet period by executing range-bound strategies, such as selling iron condors on near-month options.
Historically, prolonged Federal Reserve pauses lead to a sharp decline in Treasury market volatility. For example, during previous extended pauses, the ICE BofA MOVE Index, which measures bond market volatility, has dropped significantly below its historical baseline. We recommend writing options on short-to-medium term Treasury futures to capture premium decay as this implied volatility continues to compress in the coming weeks.
Positioning for Shifting Rate Path and Managing Downside Risk
As we look toward the projected rate cuts in late 2027, the yield curve is highly likely to undergo a gradual disinversion and steepening. Since the Fed is expected to hold rates steady through the rest of this year before eventually cutting to 3.25% by end-2027, we should prepare for a shifting curve. We advise entering into curve steepener positions, utilizing options on 2-year and 10-year Treasury notes to profit from this widening spread.
Despite this steady outlook, we must remain mindful of the lingering upside risks fueled by geopolitical tensions and volatile energy markets. Historically, sudden spikes in oil prices have quickly reignited inflation fears and forced the Fed’s hand. To hedge against the non-negligible risk of sudden policy tightening, we suggest holding cheap, out-of-the-money payer swaptions as a protective buffer.
