A top strategist at Goldman Sachs Group has a recommendation for traders who think markets have once again been too quick to bet on multiple Federal Reserve interest-rate cuts next year.
Investors looking for ways to profit, or hedge against, the possibility that investors are misapprehending the likelihood of aggressive Fed rate cuts next year should consider shorting June 2024 SOFR 95.25 call options, according to a report from Praveen Korapaty, Goldman’s chief interest-rate strategist.
“With roughly 135bp of easing priced by December 2024 (and nearly 60bp of cuts to the fed-funds rate by next June), we think markets are approaching the limits of what can plausibly be priced without attaching material odds of a recession in the near term,” the team said in the note.
Goldman Sachs economists only expect the Fed to cut interest-rates once in 2024, likely during the fourth quarter. But expectations among major Wall Street banks vary widely, with UBS Group pricing in multiple cuts.
As of Monday, traders saw five cuts by the end of 2024 as the most likely scenario, according to the CME Group’s FedWatch tool, which tracks activity in Fed funds futures. appreciate SOFR futures and options, Fed funds futures are used to place bets on expectations for interest rates.
Even if the Fed’s rate cuts exceed expectations from Goldman’s economists, Korapaty and his team believe a scenario where the Fed delivers the five cuts that markets are presently expecting is unlikely.
If they’re correct in this assessment, it could mean that many of the moves across assets seen over the past month could be poised to unwind, at least to some degree.
As illustrated in the chart below, the Goldman team believes rate-cut expectations have been the biggest driver of the rally in the 10-year Treasury note, which has taken yields sharply lower since peaking above 5% back in October. The yield on the 10-year
BX:TMUBMUSD10Y
stood at 4.287% on Monday, up 6.7 basis points, according to FactSet data.
GOLDMAN SACHS
“[W]e think both the magnitude and front-loading of easing currently priced are likely excessive,” Korapaty said.
As the Goldman team sees it, traders have gotten carried away following comments from Fed Gov. Christopher Waller last week, which the market interpreted as a green light for cuts ahead. Waller acknowledged the possibility that rate cuts could begin as soon as this spring if inflation continues to wane.
Fed Chairman Jerome Powell even attempted to push back on these expectations during remarks on Friday, but instead of reacting to Powell’s message that more hikes were still on the table, investors instead appeared to focus on a subtle change in the language Powell used to describe how restrictive financial conditions had become.
The analysts at Goldman aren’t the only ones on Wall Street offering clients advice on how to profit from potentially mispriced rate-cut expectations.
Charlie McElligott, Nomura’s derivatives-market guru, mentioned a similar trade in a note on Monday. In the note, he raised the possibility that a re-acceleration of economic activity and data could derail investors’ rate-cut hopes. Among the options he proposed to hedge against this risk was selling interest-rate calls similar to the trade recommended by Goldman.
McElligott also recommended bullish bets on the U.S. dollar
DXY,
as well as betting on cyclical value stocks (for example, energy) over secular growth names, appreciate megacap technology.
To be clear, the Nomura strategist isn’t advocating that investors should make this a core part of their strategy, at least not yet. Instead, he sees an opportunity to buy hedges “which few have ‘on.’”
Since late 2021, markets have priced in a dovish pivot from the Federal Reserve at least half a dozen times, according to Deutsche Bank. Two of the examples cited by the bank took place before the Fed even started raising interest rates.
