With so much uncertainty in the markets right now as a result of tariff news, it becomes difficult to know what data to watch and what data to ignore. For instance, the first Friday of April had the non-farm payroll numbers, however, since they were looking back a month, the market was clear that the news from the report may not matter. This ‘hard data,’ which can be quantified, takes time to collect and may not provide the most current signal for the market.

At times like this, the market will often focus more on ‘soft data.’ This data is based on surveys that ask different groups of people what they think might happen going forward. Watching changes in this soft data could give indications not only to the market, but also to the Federal Reserve, of the impact of the tariffs and changes in trade policy. In the last two weeks, the market received data from two important sources. The first is the ISM data, which does a good job of leading the economy and the market. The headline ISM report dropped below the 50 line, which gave markets some pause because it appeared as if growth was waning. However, the internal evidence of this report may have been even worse. First, the new order index, showing how many new orders suppliers are expected to place, fell sharply to levels last seen in 2022. Additionally, the prices paid measure within the report rose sharply to levels last seen in 2022. The interpretation from the report was a strong concern of the market for stagflation, which is when growth is slower than expected and inflation is higher than expected.

The other piece of soft data came from the National Federation of Independent Business. This small business measure, which had risen sharply after Trump was elected President, fell sharply for the second consecutive month. In addition, the internal evidence of this report was equally negative for the market. The level of business uncertainty rose sharply. The measure of business conditions also fell, and the level of prices paid rose. Another report that gave the indication of stagflation. This meant business, large and small, were fearing stagflation going forward.

If I go to ChatGPT, I can pull up a summary of comments from Federal Reserve officials over the last several weeks. Many of them, including those from Chairman Powell, tell a story where the impact of tariffs on the U.S. economy may be one where growth is slowing but where inflation is higher than they would like. Recall, the FOMC has a dual mandate of price stability and full employment, so a move higher in inflation but worse in growth gives no clear direction as to what this policy should be.

St. Louis Fed President Alberto Musalem highlighted this conundrum in comments. He highlighted the importance of maintaining restrictive policy until it became clear that inflation was clearly moving back to target. In fact, he warned that if inflation expectations became unanchored, more aggressive policy might be needed to restrain them. In some ways, he is letting the consumer tell him whether higher prices or higher unemployment is a bigger concern.

It is important to pay attention to inflation expectations. While there are a few different measures, one measure that the market watches is the University of Michigan measure of inflation expectations one year forward. As one can see from the chart, since the start of the year, this measure has moved from 2.5% to 5%. Could this be a case of inflation expectations becoming unanchored? Consumers are expecting price increases at the fastest pace since 2022, much like businesses. Could this suggest that the FOMC may not be as quick to cut rates as the market thinks?

What exactly is the market pricing in for FOMC rate expectations going forward? According to CME FedWatch, the top chart shows that there are currently only 33% odds of a rate cut at the May meeting. Looking at June and July, cuts are now expected at each meeting. One could argue that trades in the Fed Funds futures market are getting pretty bullish, perhaps too much so given the potentially unanchored inflation expectations.

I can now use STIR Analytics to assess the basis between Fed Funds and SOFR. The chart above shows that the basis is currently just above zero suggesting that the Fed Funds rate and SOFR rate are approximately the same right now. That allows us to use our views of potential Fed Funds to trade SOFR. Trading the Three-Month SOFR futures, market participants are looking at market expectations for the path of rates over a three-month period. If the Fed does not cut in May, and even mentions inflation expectations, there is a possibility that the market will begin to expect higher rates over the three-month period. This would result in SOFR futures trading lower, as the futures price is 100 – the expected rate over the period.

While there is a possibility that Three-Month SOFR futures could fall because of unanchored inflation expectations from both consumers and businesses, I can see that SOFR traders right now are expecting quite a different outcome. In fact, the sharp rally in the past month in SOFR futures to 96.275 points to a rate of 3.725%, considerably lower than a rate above 4% (futures below 96) only one month ago. Could futures head back below 96 if the market begins to realize the FOMC is not going to be as aggressive cutting rates as is expected?

Traders may look to fade the move higher in SOFR futures, looking for fewer rate cuts than are priced into the Fed Funds futures market. However, in very volatile markets, it is often preferred to find a way to do so with defined risk. Often this means buying options, but given the increase in implied volatility, this can also bring risk. A way to limit the amount of theta or time decay risk, while still having defined risk and reward, is to consider selling a call spread and using the proceeds to reduce the cost of the puts the trader buys. The expected return of this spread can be seen in the graph above. The maximum risk for the spread is the difference between the call strikes – 20 ticks.  The maximum gain is unlimited below the 96 put strike. If rate expectations go back to where they were earlier this year, there are at least 20 ticks to gain.

In a market with a lot of volatility and uncertainty, it is important to use the tools provided to not only assess the possible outcomes, but also to find definable rewards to risk ways to express your views. With the suite of tools and products from CME Group, traders are able to do exactly that.

Good luck trading!

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