Economic Growth Slowdown
Monetary policy remains restrictive, yet closer to neutral than last year. Risks are upward for inflation and downward for employment, necessitating a careful policy approach. The Federal Reserve’s revised framework, updated in 2025, removes certain language concerning the zero lower bound and embraces flexible inflation targeting.
The Federal Reserve maintains a commitment to adaptability, ensuring well-anchored long-term inflation expectations and a balanced approach when inflation and employment goals are not aligned. Their strategy is to achieve maximum employment and a 2% inflation target with transparency and accountability.
Market Volatility Ahead
The message is that the Federal Reserve is trapped between slowing growth and persistent inflation, creating significant uncertainty. This data-dependent “proceed carefully” stance suggests a period of elevated market volatility is ahead. We believe positioning for this through options, such as buying VIX call spreads or straddles on the S&P 500 ahead of the September jobs report, is prudent, especially as the VIX has already climbed to hover near 19.
The new policy framework effectively shelves the idea of a quick pivot to rate cuts that many had hoped for. With core PCE inflation holding at 2.9% and new tariff pressures, the bar for easing policy is now much higher. We expect the yield curve to flatten further as a result; the 2s10s Treasury spread, which recently dipped to -15 basis points, is likely to deepen its inversion.
The risk that tariffs create more than just a one-time price bump is being underestimated. The Fed says it will not allow this to become ongoing inflation, but we see upward pressure on market-based inflation expectations. For example, 5-year breakeven rates have already climbed by 10 basis points to 2.4% since the tariff news, suggesting derivatives that protect against higher-than-expected inflation are becoming more valuable.
With payroll growth collapsing to just 35,000 per month and H1 2025 GDP slowing to 1.2%, downside risks to the economy are now the primary concern. This environment is unfavorable for cyclical sectors that rely on strong economic expansion. We are therefore using options to gain downside exposure to industrial and consumer discretionary indices, which we saw underperform during the last earnings cycle.
The Fed’s updated framework, which removed the dovish “shortfalls” language on employment, gives them more leeway to keep policy tight even as the unemployment rate ticks up to 4.2%. They have explicitly restored the option for preemptive action if wage growth threatens their inflation goal. This reinforces our view that the central bank will tolerate more economic pain than it would have under its previous 2020 guidance.
