US two-year yields have dropped by 10 basis points, hitting their lowest since the spike on Liberation Day. This change shows that the market is reevaluating the Federal Reserve’s expected rate path, hinting at a possible shift in monetary policy. Concerns about Trump’s tariffs had raised doubts about growth and inflation. Now, there are signs of slowing growth and a weaker jobs outlook. This has led to expectations of significant rate cuts from the Federal Reserve, with predictions of 136 basis points of easing in the next year, possibly lowering Federal funds to around 3%.

Delayed Inflation Effect

There is worry that tariffs might cause delayed inflation effects, which could restrict the Federal Reserve’s ability to cut rates as planned. This situation highlights the need to keep a close eye on future inflation data to inform economic policy decisions. With two-year yields dropping sharply, the market is clearly signaling a desire for deep Federal Reserve rate cuts. The August jobs report, showing only 95,000 new jobs, supports the view that the economy is weakening. As a result, the market anticipates more than a full percentage point of cuts in the coming year. We are looking at long positions in short-term interest rate futures, like those linked to SOFR, to benefit from the expectation of lower rates. As the Fed hints at more easing due to weakening growth, the value of these contracts should keep rising. This is a straightforward way to express the market’s current direction. Buying call options on two-year Treasury note futures is another appealing strategy. It offers potential gains if yields continue to fall while limiting our risk. The memory of the sharp yield spike on Liberation Day reminds us that volatility can hit quickly, and this approach shields us from sudden reversals.

Risk Of Inflation Spike

The biggest risk is that tariffs trigger a delayed inflation spike, which could limit the Fed’s options. The last core CPI reading from August remained high at 3.4%, raising concerns. Therefore, we should monitor upcoming inflation reports closely, as any surprising rise could rapidly unwind expectations for rate cuts. To prepare for this risk, we can use options straddles around key inflation data release dates. These positions will profit from significant market movements in either direction—whether a sharp drop in yields due to a weak economy or a surge from unexpected inflation. Reflecting on market swings in 2022, we know how quickly the narrative can shift from growth fears back to inflation fears. Create your live VT Markets account and start trading now.

here to set up a live account on VT Markets now