The chart above shows the prices of the generic second, sixth and 12-month futures in the Fed Funds market. I have picked these somewhat at random but with the goal of showing the market’s expectation for rate cuts in the short, medium and long term. This allows me to see how quickly a Fed rate cut cycle develops and try to get a sense of how aggressively the market is pricing it.  One can see in the generic 12-month futures that there are 200 bps of rate cuts priced into the next 12 months, with 50 bps expected to come in the next 2 months. This re-pricing of Fed expectations over the past three months is much more dramatic than the aggressive cuts that were priced into Fed Funds futures at the end of 2023, which were largely reversed over the first five months of 2024. This begs the question for market participants of whether the market is pricing in Fed policy that is too aggressive. If the economy does achieve a soft landing, are this many rate cuts needed?

To see not only what is being priced into the Fed Funds market, but to see the probabilities at each meeting, and then cumulatively over the cycle, I look to the CME FedWatch. This tool very simply and effectively gives traders a good understanding of the perceived odds of each outcome at the various FOMC meetings in the next year. In the top chart, I look at the absolute probabilities per meeting. This shows, for instance, that there is a 63% odds of a 25 basis point rate cut and 37% odds of a 50 basis point cut for the September meeting. Looking at the November meeting, I see 50% odds of Fed Funds being in the 4.5% – 4.75% range vs. the current 5.25% – 5.5% range. This suggests that market participants should see cumulatively 75 basis points of cuts by the November meeting, whether those come in September or November. 

The lower panel perhaps demonstrates this more clearly as it shows the cumulative probability. It suggests that this outcome i.e. 4.5% – 4.75%, has 89% odds of occurrence, with rates of 4.75% – 5% or 50 basis points cumulatively only at 11% odds. Said another way, the market apparently feels quite strongly that Fed Funds will be 75 basis points lower than where they are now by the end of the November meeting, however those cuts are spread out. One can use this tool to look at any meeting to see the cumulative odds and the most expected ending level for Fed Funds by a particular meeting. So when one asks if rate cuts that are priced in are too aggressive, what they really might be saying is if there’s really an 89% chance that rates will be 75 basis points lower by November, for example.

What is driving the market’s perception of what the Fed will do? It has largely been the economic data that has come out. I would like to refer to the Citi Economic Surprise Index which measures how data comes out relative to expectations. It does not tell us if the economy is strong or weak in absolute terms, only whether it is above or below expectations. When it is below expectations, the index moves lower. When it is above expectations, the index moves higher. Thus, it tends to mean revert over a longer period of time because if data is consistently higher than expectations, analysts tend to raise expectations and at some point, the data will disappoint, and vice versa. 

I have inverted the Citi Economic Surprise Index in white above. I overlay this with the generic third Fed Funds futures which currently settles at the end of November, thus capturing the next two FOMC meetings. One can see over the past year, the declining data has coincided with the market pricing in more cuts. From January until April, data improved, and so rate cuts stopped being priced in. However, since April and over the entire summer, markets saw a large decline in the data relative to expectations which led to the more aggressive pricing of rate cuts that market participants saw in earlier charts.

What has been the primary driver of the weaker Economic Surprise Index? The jobs market. This is particularly interesting because the primary difference between those traders looking for a soft landing vs. those expecting a hard landing comes down to the outlook for labor. Labor has been declining steadily, bringing the Economic Surprise Index with it. 

I look at a number of different labor metrics, and not just the nonfarm payroll, but one might consider that here first. One can see that the NFP number has fallen from numbers that were in the 250K – 300K region at the end of 2023 and early 2024 to levels more like 100K – 150K, basically half of what markets had seen just nine months ago. Confirming this trend, I look at the data from the Conference Board. This survey has two components which I compare in a ratio here – jobs plentiful and jobs hard to get. When this ratio is falling, there are fewer jobs available and survey members see a difficult labor market. When it is rising, the labor market is seen to be strong. One can see over the past year, the jobs plentiful vs. hard to get, the nonfarm payroll and the Citi Economic Surprise Index have all moved together. Thus, one might infer that the move in Fed Funds futures may be primarily linked to the action taking place in the labor markets.

One criticism of an aggressive Fed policy is that financial conditions would ease too much, potentially increasing inflation expectations and possibly inflation itself. One can see the link between financial conditions and Fed Funds futures. In order to line them up, I use the Bloomberg Financial Conditions Index (inverted) and the third contract in futures. One can see there is a tight fit over the past year but recently, while aggressive rate cuts are priced in, financial conditions have not eased. This possibility still exists, and it is a risk in the minds of some bond investors, who are naturally worried about inflation re-igniting given the losses that these investors faced in 2022 when inflation was strong. If this cadre of investors gets its way, it is possible the FOMC may not cut rates as rapidly as the market is currently pricing in.

As I mentioned before, the deteriorating conditions in the labor market has led some to think the landing in store is harder rather than softer. This is potentially contributing to the more aggressive rate cut expectations. The risk is the labor market is not that bad, in which case rate cuts lead to easier financial conditions and a risk of inflation problems reigniting. Are there any measures of the labor market that suggest things are not that bad? Actually, there are. One measure is the aggregate weekly hours of private employees. This takes the total number of private employees and multiplies by the average weekly number of hours worked. One can see that when it has risen in the past, the economy has been fine and only when this measure drops do markets see a recession. 

I also compare this metric to the Fed Funds target rate. One can see that the Fed is not typically looking to cut rates aggressively until this measure drops. Could this be a signal that the rate cuts priced in, 75 basis points of cuts by November, may be too dramatic given the data?

If I take the view that a trader is of the opinion that the labor data is not as bad as some in the market fear, this could potentially mean the Citi Economic Surprise Index begins to improve and perhaps the market looks to price rate cuts less aggressively. As there are 75 bps of cuts priced into November, the trader is not suggesting there would be no rate cuts before then, just that the total might be less than that. How would one set up that trade? For me, I think the best expression of that idea is to use a 1 by 2 put spread. 

I would set this up as a breakeven trade where I am less worried about the Greeks right now. I would buy the at-the-money 95.3125 puts which imply 100-95.3125 or 4.6875% as the expected level in November. In buying these puts, I would be betting futures are lower or rates are higher than this level. Like I said, though, it may not be that there will be no rate cuts. There could be some. In fact, with an FOMC meeting happening asap, and the Fed unlikely to disappoint the market, a rate cut of 25 bps in September seems all but assured. Therefore, I am happy to sell the 95 puts that go in the money if the Fed Funds rate is above 5% at expiration. In fact, I would sell two of these puts and use the premium from those options to make the entire spread zero cost. 

This allows me to bet that rates are above 4.6875% but at or below 5% by November expiration. In doing this spread, I take in a small amount of premium, so if I am completely wrong, and Fed Funds futures head much higher because of more rate cuts, I would actually still make a small amount of money. The risk to my strategy is Fed Funds futures are much lower than 95. My breakeven is 94.674 or 5.326% in Fed Funds. As long as rates are below that level I will make some money. This seems like a pretty safe range for me to be profitable on this idea. 

Using options spreads, and particularly ratio spreads when a trader can lean against certain levels in the market, traders are able to set up ideas with very attractive reward to risk. The more asymmetric reward to risk opportunities a trader has, the better their P&L may ultimately be. Using the tools provided by CME Group, a trader can find out what the market is pricing in and try to trade against the more extreme views in the market. 

Good luck trading!

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