Following Trump's nomination of Kevin Warsh as the new Federal Reserve Chair, market expectations for easing surged temporarily, but the sentiment has shifted. Traders are now betting on only two to three interest rate cuts by 2026. Tonight’s non-farm payroll data will be the key litmus test for validating this cautious outlook.
Short-term interest rate traders are gradually forming a consensus bet: this wager will profit if the Federal Reserve cuts interest rates only two or three times this year.
Since Trump nominated Kevin Warsh to head the Federal Reserve earlier this month, traders have been piling into positions betting on a dovish shift by the Fed. However, ahead of the closely watched labor market data due for release on Wednesday, their bets have become slightly more conservative.
Option flows linked to the Secured Overnight Financing Rate (SOFR) indicate demand for so-called 'condor options,' which target one of two scenarios: the Fed cutting rates by 25 basis points either twice or three times by 2026. SOFR closely tracks market expectations for the path of the Fed's policy rate.
Meanwhile, over the past few weeks, similar hedging operations targeting future interest rate volatility have emerged in the interest rate swaps options market. Strategists at Barclays noted that since Warsh's nomination, interest rate volatility has risen, with investors showing a preference for establishing long positions in longer-dated bonds.
In a report, strategists Amrut Nashikkar, Eveline Dong, and Charley Chau stated, 'Investors are seeking to establish a duration exposure biased towards bullishness to respond to a more dovish Federal Reserve, but they do not anticipate aggressive rate cuts,' adding that their 'target is no more than two to three additional rate cuts.'
The recent activity in the options market occurred ahead of the key January non-farm payrolls report. Tonight at 21:30, the U.S. will release the report, with expectations that the data will reveal a weakening or stalling U.S. labor market, potentially altering market expectations for Fed policy.
Currently, pricing in the swaps market shows about a 30% probability of a third 25-basis-point rate cut this year, while two cuts are almost fully priced in by the September meeting. This is an increase from a week ago, when the market was pricing in less than 50 basis points of cumulative rate cuts by December. Tuesday’s weaker-than-expected retail sales data further bolstered momentum toward a dovish shift in expectations.
Impacted by the retail sales data, U.S. Treasury prices rose on Tuesday, with yields falling to their lowest levels in the past month.
The market had speculated that after Warsh takes over from Powell as chairman, he would likely heed Trump’s repeated calls for the central bank to cut rates. However, given persistently stubborn high inflation and the hawkish stance of some Fed policymakers, Warsh may not aggressively slash rates. If confirmed by the Senate, Warsh will officially take the helm of the Federal Reserve in time for the June policy meeting.
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