Market expectations for monetary easing initially surged following former President Trump's nomination of Kevin Warsh to lead the Federal Reserve, but the sentiment has since shifted. Traders are now positioning for only two to three interest rate cuts by 2026. Tonight's nonfarm payrolls report will serve as a critical test for this cautious outlook.
A consensus is emerging among short-term interest rate traders: a bet that the Federal Reserve will implement just two to three rate cuts this year stands to yield profits. Since Trump nominated Warsh earlier this month, traders had been accumulating positions anticipating a more dovish stance from the Fed. However, ahead of Wednesday's highly anticipated employment data release, these positions have become slightly more conservative.
Flow data from options tied to the Secured Overnight Financing Rate (SOFR) indicate demand for so-called "condor options," which target one of two scenarios: the Fed enacting either two or three 25-basis-point rate cuts in 2026. SOFR closely tracks market expectations for the path of the Fed's policy rate.
Concurrently, similar hedging activity targeting future interest rate volatility has been observed in the interest rate swaptions market over recent weeks. Strategists at Barclays noted that interest rate volatility has increased since Warsh's nomination, with investors showing a preference for establishing long positions in long-term bonds.
Strategists Amrut Nashikkar, Eveline Dong, and Charley Chau stated in a report, "Investors are seeking to establish a moderately bullish duration exposure in anticipation of a more dovish Fed, but are not expecting significant rate cuts," adding that their "target is for no more than two to three additional rate cuts."
The recent activity in the options market precedes the crucial January nonfarm payrolls report, scheduled for release tonight at 21:30. The data is expected to reveal a weakening or stagnating U.S. labor market, which could alter market expectations for Fed policy.
Currently, pricing in the swaps market suggests approximately 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 represents an increase from a week ago, when the market was pricing in less than 50 basis points of cumulative cuts by December. Tuesday's weaker-than-expected retail sales data further reinforced the shift towards more dovish expectations.
Influenced by the retail data, U.S. Treasury prices rose on Tuesday, pushing yields down to their lowest levels in the past month.
The market had previously speculated that Warsh, upon succeeding Jerome Powell as Chair, would likely heed Trump's repeated calls for the central bank to lower rates. However, given persistently high inflation and the continued hawkish stance of some Fed policymakers, Warsh may not pursue aggressive, substantial rate cuts. If confirmed by the Senate, Warsh would officially assume leadership of the Fed ahead of the June policy meeting.