Insights 
VT 
The Federal Reserve (Fed) Bank of San Francisco President mentioned that despite progress, inflation remains an issue, complicating policy rate adjustments.
The labour market and economic growth are performing well, but price stability hasn’t been fully achieved. Restrictive rates have been in place for years, and tariff impacts appear less severe than expected.
Potential Rate Cuts
The President noted two potential rate cuts this year, stressing they should not be preemptive. Business optimism and stable growth are observed, and any rate cuts, whether in July or September, are not the primary concern. Rates are expected to settle at or above 3%, which exceeds pre-pandemic neutral rates.
We believe derivative traders should prepare for heightened volatility around upcoming economic data releases. While the May Consumer Price Index showed a welcome slowdown to 3.3% annually, the robust addition of 272,000 jobs in the same month supports the President’s view of a strong economy that complicates timing. This data-dependent stance means any surprises in inflation or employment reports will likely trigger sharp market moves.
Given these remarks, we see little value in positioning for a July rate adjustment. Current market pricing, reflected in the CME FedWatch Tool, gives a July cut less than a 10% chance, while assigning over a 60% probability for a cut by September. This suggests that options strategies that bet against a summer move, or futures positions favouring a later start to the easing cycle, are more prudent.
Market Implications
We must re-evaluate long-term rate expectations based on the assertion that the new neutral level will be higher than in the past decade. Historically, before the 2008 financial crisis, policy rates often hovered above 3%, making this projection a return to a previous norm rather than a new hawkish stance. This implies that long-dated bond futures may not rally as strongly as previously anticipated once cuts begin, and yield curve steepening trades could underperform.
Considering the uncertainty, we view instruments tied to market volatility as attractive. The CBOE Volatility Index (VIX) has recently traded below 13, a level that signals significant market complacency. Buying VIX call options or futures could serve as an effective hedge against the market’s potential surprise if the central bank’s patience wears thin or data turns unexpectedly.
