Fed funds futures have reverted back to pre-CPI report levels, cooling down after the release of US PPI data. This data indicates a disparity in price pressures, with producers facing increased costs that have not yet evidently impacted consumer prices.
This situation suggests the eventual necessity of cost passthrough due to tariffs, potentially impacting companies further in upcoming quarters. This presents a consideration for the Fed to closely monitor inflation trends.
Rate Cut Predictions
Current trader expectations have reduced the likelihood of a September rate cut, now showing ~93% odds, down from earlier full pricing. By year-end, ~57 basis points of rate cuts are predicted, aligning with pre-CPI data levels, and down from ~61 basis points post-inflation numbers.
There remains strong anticipation for a rate cut in September, with market focus on labour market softening and tariff-driven inflation yet to appear in consumer prices. The Fed faces a delicate choice: a prudent 25 basis point cut to balance temporary tariff-induced inflation with market demands.
A 50 basis point cut is not justified by current data, as noted by policymakers. The focus now turns to Powell’s upcoming speech for guidance, though a clear steer on September expectations is not imminent. Meanwhile, the US jobs report on 5 September will be pivotal.
The producer price data from yesterday has thrown a wrench into things, showing a disconnect with the softer consumer price report from earlier this week. Producer costs are rising, but we aren’t seeing it passed on to consumers yet, which complicates the inflation picture for the Federal Reserve. This has caused us to pull back on our expectations for aggressive rate cuts.
Market Volatility
The odds of a September rate cut have dipped from being fully priced in to about 93%, according to Fed funds futures. This is a familiar pattern; we saw a similar lag in 2022 where producer price spikes eventually led to much higher consumer inflation than initially anticipated. Derivative traders should reduce exposure that relies heavily on a deeply dovish Fed, as the central bank might be more cautious.
This uncertainty is creating opportunities in the volatility market, with the VIX index creeping up towards 16 from its recent lows. This suggests that options-based strategies, which can profit from large price swings, might be prudent. Hedging long portfolios with put options or using straddles around key data releases could protect against unexpected hawkishness from the Fed.
All eyes will now be on Fed Chair Powell’s upcoming speech at Jackson Hole and, more importantly, the next jobs report on September 5th. July’s jobs report showed a slight softening, with non-farm payrolls coming in at 165,000, and another weak reading would solidify the case for a rate cut. Until then, the market is likely to remain in this state of limbo.
In practical terms, this means positions betting on a 50 basis point cut in September are now highly speculative and should be reconsidered. A more balanced approach, like using interest rate options to bet on a single 25 basis point cut while hedging against the possibility of a pause, is a more sensible strategy. We should wait for the next set of labor market data before making any high-conviction directional bets.
