Traders are anticipating nearly three 25 basis point rate cuts by the Federal Reserve by year-end. This shift follows recent US data suggesting the Fed needs to act more swiftly.
The focus was on the US CPI report, but the weekly jobless claims, the highest since October 2021, caught more attention, indicating a weakening labour market. Inflation numbers weren’t overly concerning, with headline monthly inflation at +0.4% and core at +0.3%.
Inflation’s Impact
Despite being within expectations, these figures exceed the +0.17% monthly run rate needed for easing annual inflation towards the Fed’s 2% target. Tariffs are expected to continue affecting prices until at least the end of the year.
Within the report, headline inflation was boosted by energy (+0.7%) and food (+0.5%) prices. Core inflation rose due to airfares (+5.9%) and used vehicle prices (+1.0%). Apparel prices, affected by tariffs, increased by +0.5% in August.
Tariffs influence pricing, but the market remains calm, expecting weakened job numbers to eventually depress prices. Traders are now pricing in roughly 71 basis points of rate cuts by year-end, up from 67 basis points. A 50 basis point rate cut next week is unlikely, though consecutive meeting cuts are expected.
Based on the data from this week, we are seeing a major shift in market thinking. Initial jobless claims just jumped to their highest level since October 2021, providing the clearest signal yet that the labor market is weakening significantly. Consequently, the market is now pricing in nearly 75 basis points of Fed rate cuts by the end of this year.
Market Response
This creates a dilemma, as inflation is not cooling nearly as fast as the job market. The latest monthly core inflation reading of +0.3% keeps the annual rate stubbornly high at around 3.5%, well above the Fed’s 2% target. Much of this is driven by rising energy costs and the noticeable impact of trade tariffs on consumer goods.
For derivative traders, this points towards positioning for lower interest rates ahead. We should consider buying call options on Secured Overnight Financing Rate (SOFR) futures, which profit as expectations for rate cuts increase. This strategy offers a defined-risk way to bet on the Fed prioritizing the weakening economy over the still-hot inflation numbers.
The conflict between slowing growth and sticky prices is also a recipe for higher market volatility. The VIX index, a measure of expected market turbulence, has already climbed from recent lows near 14 to over 17 this past month. Buying VIX call options or futures could be a prudent hedge against any upcoming economic data that spooks the market further.
We can look back to the Fed’s actions in 2007 for a historical parallel, when the central bank began cutting rates in response to a deteriorating economy, even though inflation was not fully under control. The market is now betting that the weakening labor data will force a similar pivot. This makes trades that benefit from falling rates and rising volatility particularly relevant in the coming weeks.
