Shifting Rate Cut Expectations
Before the outbreak of hostilities, markets priced in just over two US Federal Reserve rate cuts by year-end. Since then, pricing has moved to well under two cuts, pointing to less dovish expectations. The Federal Reserve is also dealing with sticky inflation and waning labour demand. BNY expects three rate cuts this year. The ongoing conflict in the Middle East is creating a negative supply shock for the U.S. economy. We see this hitting through higher oil prices, which are currently keeping Brent crude futures hovering around $98 a barrel, and through general market uncertainty. This situation complicates the path forward for interest rates. The Federal Reserve faces a dilemma between persistent inflation and slowing growth. The latest Consumer Price Index report for February showed inflation remains stubborn at 3.1%, leading many in the market to scale back rate cut expectations. In fact, Fed funds futures now imply only a 40% chance of a second rate cut by December.Trading Hedges And Volatility
However, we believe the focus should be on the weakening labor market, which will ultimately force the Fed’s hand. The most recent jobs report showed a gain of only 150,000 nonfarm payrolls, missing forecasts, while the unemployment rate ticked up to 4.1%. We are therefore maintaining our view that three rate cuts are likely this year, contrary to current market pricing. For derivatives traders, this sets up an opportunity in interest rate futures. Options on SOFR futures that would profit from a drop in rates later this year appear mispriced relative to our outlook. Positioning for a steeper decline in the forward curve than the market currently anticipates could be a favorable strategy in the coming weeks. The broad economic uncertainty also suggests higher volatility ahead. The Cboe Volatility Index (VIX), which saw lows near 12 back in 2025, has been establishing a higher base recently. Traders should consider buying VIX calls or call spreads as a hedge against a sudden market downturn triggered by geopolitical events or a surprisingly weak economic report. In the energy sector, the elevated oil prices create a two-way risk. A sudden de-escalation could send prices tumbling, while a wider conflict could cause another major spike. Using options strategies like straddles on oil ETFs can allow traders to profit from a large price move in either direction while keeping risk defined. Create your live VT Markets account and start trading now.
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