Federal Reserve Chair Powell recently spoke to the National Association for Business Economics and noted that the economic outlook remains the same since September. The Fed lowered interest rates by 25 basis points at that time, primarily to address labor market risks stemming from supply-side issues. The “dot plot” indicates a median expectation of two more interest rate cuts this year, but most people do not expect any additional reductions. Market predictions, however, align with plans to adjust the Fed’s base case, suggesting cuts in both October and December. Overall, a reduction of 75 basis points over the next year is anticipated, occurring at a rate of 25 basis points each quarter. This would lead to a Fed funds rate upper limit of 3.00% by September 2026.

Policy Outlook and Inflation Risks

The current policy is seen as less strict than the Federal Open Market Committee believes, raising the chance of inflation risks due to early easing measures. Although the AI boom is less sensitive to interest rates, it’s becoming more financed by debt and could expand with lower rates. Planned fiscal easing next year may add to demand-driven inflation. Tariff-induced inflation will also play a role, possibly affecting future Fed forecasts. Revised inflation and growth estimates are expected in the upcoming Global Outlook. With the Federal Reserve signaling rate cuts in both October and December, the path for policy appears straightforward. The latest jobs report for September 2025 showed a slowing labor market, with payrolls increasing by only 150,000 and unemployment rising to 4.1%, justifying the Fed’s stance. Traders should keep positions that benefit from falling short-term interest rates in the near future. Since the market has already accounted for these two 25 basis point cuts, straightforward trades in Fed Funds or SOFR futures may offer limited gains. Instead, traders might explore options strategies that take advantage of this high level of certainty. For instance, selling out-of-the-money puts on short-term rate futures could provide a way to earn premiums as the market anticipates the Fed’s expected cuts. However, we believe the main risk is that the Fed might be making a policy error by concentrating on the labor market while ignoring inflation. The Consumer Price Index report for September 2025 showed a higher-than-expected inflation rate of 3.8%, with core inflation stubbornly over 4%. This situation resembles what occurred in 2021 when the Fed initially overlooked rising inflation, necessitating aggressive tightening later.

Strategies for Potential Market Scenarios

This cycle of early easing is taking place as an AI-driven investment boom becomes increasingly reliant on debt, which will be further boosted by lower rates. Recent industry analysis shows that corporate debt issuance for AI infrastructure has increased by 30% compared to last year. This, combined with expected fiscal stimulus, is creating significant pressure for demand-driven inflation. Given this outlook, a yield curve steepening trade could be profitable. This strategy involves using derivatives to bet that long-term rates will rise due to inflation concerns, even as the Fed cuts short-term rates. Taking a long position in 10-year Treasury note futures while shorting 2-year futures would directly benefit from this divergence. For a longer-term strategy, traders should consider buying derivatives that could profit if the Fed is forced to abruptly change its policy in 2026. Purchasing call options on SOFR futures for mid-2026 delivery is a relatively low-cost way to hedge against this potential risk. This positions the trader for the chance that the current easing pathway will eventually create an inflation problem that requires a more aggressive response later on. Create your live VT Markets account and start trading now.

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