Monetary Policy Signals

Neel Kashkari from the Federal Reserve expects two more quarter-point rate cuts this year. He backed the recent rate cut, seeing it as a way to address a possible rise in unemployment. Kashkari believes the neutral rate might be up to 3.1%. The Fed’s policy could be less strict than before. Kashkari suggests that if the job market weakens, rates could be lowered quickly. However, if jobs stay strong or inflation rises, the rate should remain steady. He is also open to increasing rates if economic conditions shift. Kashkari thinks inflation will likely stay below 3% due to tariffs, but he acknowledges that future rate hikes are possible. Although he won’t be voting this year, he will next year and continues to hold a hawkish view. With the Federal Reserve having just cut rates this week, the expectation for two more quarter-point cuts this year provides a clear direction for short-term interest rate derivatives. Investors should focus on December 2025 and January 2026 SOFR futures, anticipating a policy rate that could be half a point lower by year-end. This view is supported by the August jobs report, where unemployment increased to 4.2%, giving the Fed reasons to act proactively. The primary risk to this dovish approach is the labor market. Therefore, upcoming Non-Farm Payroll reports will be crucial trading events. The warning that policy could pause if the labor market remains strong suggests we should prepare for more volatility around these releases. Using options straddles on equity indices or bond ETFs could be a strategy to benefit from the potential sharp moves following the next employment figures.

Watching Economic Indicators

We need to keep an eye on inflation data. The latest Core PCE reading of 2.8% is still above the 2% target. A surprise rise in the next CPI report could quickly change expectations about the remaining rate cuts. The inflation shock we saw in 2022 means any sign of rising inflation could significantly affect the bond market. For equity derivatives, this information creates a complicated picture where bad economic news may actually help the market. We can look for opportunities in rate-sensitive sectors like technology and real estate by using call spreads. However, due to concerns about a potential rise in unemployment, it’s wise to have some downside protection, such as puts on the broader S&P 500. In the long run, the idea that the neutral rate has increased to around 3.1% marks a significant change from the beliefs of the past decade. This suggests that, even after this cutting cycle ends, rates won’t drop back to the lows we saw after 2008. This could set a limit on how low long-term yields can go, affecting the pricing of options with expirations far into 2026. Create your live VT Markets account and start trading now.

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