The US two-year yields have decreased by 10 basis points, marking the lowest level since the Liberation Day spike. This change reflects a market reassessment of the Federal Reserve’s expected rate path, indicating a potential shift in monetary policy.
Previously, concerns about Trump’s tariffs suggested uncertainty around growth and inflation. Current indications suggest a weakening growth and jobs outlook, leading to the expectation of substantial Federal Reserve rate cuts. For the upcoming year, 136 basis points of easing is anticipated, potentially bringing Federal funds down to approximately 3%.
Delayed Inflation Effect
There is concern over the possibility of delayed inflation effects from tariffs, which could hinder the Federal Reserve’s ability to cut rates as planned. This scenario underscores the importance of closely monitoring future inflation data to guide economic policy decisions.
With two-year yields falling so sharply, the market is sending a clear signal for deep Federal Reserve rate cuts. The August jobs report we saw this morning, which showed a significant slowdown to just 95,000 new jobs, reinforces the view that the economy is weakening. This has pushed the market to price in over a full percentage point of cuts in the coming year.
We are looking at long positions in short-term interest rate futures, like those tied to SOFR, to directly play this expectation for lower rates. As the Fed signals more easing in response to the weakening growth picture, the value of these contracts should continue to rise. This is the cleanest expression of the market’s current direction.
Buying call options on two-year Treasury note futures is another attractive strategy, offering upside if yields continue to fall while limiting our risk. The memory of the sharp yield spike on Liberation Day reminds us that volatility can emerge quickly. This approach protects us from a sudden reversal.
Risk Of Inflation Spike
The main risk is that tariffs cause a delayed inflation spike, tying the Fed’s hands. We saw the last core CPI reading in August remain elevated at 3.4%, which is a concern. Therefore, we should watch upcoming inflation reports very closely, as any upside surprise could violently unwind these rate cut expectations.
To prepare for this risk, we can use options straddles around key inflation data release dates. These positions will profit from a large market move in either direction, whether it’s a sharp drop in yields from a weak economy or a spike from unexpected inflation. Looking back at the market swings in 2022, we know how quickly the narrative can flip from growth fears back to inflation fears.
