In September, the University of Michigan reported that the five-year consumer inflation expectation in the United States was 3.7%. This figure came in slightly below the anticipated 3.9% forecast.
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With today’s consumer inflation expectation data coming in softer than anticipated at 3.7%, the market narrative for Federal Reserve rate cuts is gaining significant traction. This follows the August PCE inflation report, which also pointed towards cooling price pressures. After the persistent inflation we battled through in 2023 and 2024, this trend solidifies the view that the Fed has room to ease policy.
Interest Rate Derivatives and Investment Strategy
We should be looking at interest rate derivatives to position for this dovish shift in the coming weeks. The pricing in the SOFR futures market already indicates a growing probability of a rate cut before the end of the year. Based on current CME FedWatch Tool probabilities, traders are now pricing in a greater than 70% chance of a cut by the December meeting, a sharp increase from just a month ago.
This environment is creating a clear drag on the US Dollar, making foreign currency options attractive. Given that implied volatility in the EUR/USD pair has been hovering below a 7% annualised rate for much of the past quarter, purchasing call options could be a cost-effective strategy. This allows us to capitalize on potential upside toward the 1.1700 level with a defined risk profile.
Gold is also a major focus, as it benefits directly from falling real yields and a weaker dollar. With the metal pushing towards $3,800 an ounce, we are looking at call options on gold futures as a leveraged way to participate in the rally. Historically, periods of Fed easing, such as the cycle that began in 2019, have provided strong tailwinds for precious metals.
Finally, the prospect of a more accommodative Fed should reduce overall market anxiety, putting downward pressure on equity volatility. We could consider strategies that profit from a decline in the VIX, which has been averaging around 16 for the last several months. Selling out-of-the-money call spreads on VIX futures is one way to express the view that a major market shock is unlikely as the Fed moves to a cutting stance.
