Introduction
In the latest FOMC meeting, the Fed chose to keep the policy interest rate unchanged; however, the tone revealed in the statement sparked a reevaluation of future economic risks in the market. The Fed's concern over economic uncertainty is gradually increasing, emphasizing the parallel challenges of inflation and unemployment risks.
With the delay in policy expectations, the market's view on the rate cut timeline has undergone a significant shift, and dynamics in the SOFR options market also reflect a high degree of uncertainty about future interest rate trends, with some traders beginning to question the likelihood of a rate cut within 2025.
FOMC Decision Summary: Policy remains unchanged, emphasizing rising risks and uncertainty
This Thursday, May 8, the Fed maintained the interest rate unchanged at the May FOMC as the market expected, keeping the federal funds rate in the range of 5.25% to 5.50%, marking the third time since the rate cut cycle began in September 2024 that the rate has been unchanged.
The Fed's statement on current policy: 'Although fluctuations in net exports have affected the data, recent indicators show that economic activity continues to expand steadily. The unemployment rate has stabilized at low levels in recent months, and the labor market remains robust. The inflation rate is still slightly high. The committee seeks to achieve maximum employment and a 2% inflation rate over a longer period. The uncertainty of the economic outlook has further increased. The committee is concerned about the risks facing its dual mandate and judges that the risks of rising unemployment and rising inflation have increased.'
To achieve its goals, the committee decided to maintain the target range for the federal funds rate at 4.25% to 4.5%. In considering the extent and timing of any additional adjustments to the target range for the federal funds rate, the committee will carefully assess future data, the evolving outlook, and the balance of risks. The committee will continue to reduce its holdings of Treasuries, agency bonds, and agency mortgage-backed securities. The committee is firmly committed to supporting maximum employment and restoring the inflation rate to the 2% target.
From the wording of the statement, some things can be understood. First, the Fed chose to ignore the first-quarter GDP report, which showed a 0.3% decline in GDP for that quarter. There is not much elaboration on the weak GDP data for the first quarter; for detailed content, please refer to this article: (Is the Illusion of Prosperity Under Tariffs? The Real Economic Test for the US is in Q2)
Although the policy statement continues the past narrative of 'steady expansion' and 'robust labor market,' the wording has significantly turned cautious compared to the past, for the first time explicitly mentioning 'increasing economic uncertainty' and 'the risks of rising unemployment and inflation are intensifying,' indicating that the Fed's concern over potential stagflation risks is increasing.
Recently, inflationary pressures have resurfaced, partly related to the cost transmission effects of the new round of tariff increases. The April PCE price index and several core component indicators showed signs of recovery, significantly cooling the originally expected rate cut in June.
Fed Chairman Powell repeated the word 'wait' more than 20 times during the post-meeting press conference, reflecting that the current policy thinking has gradually shifted from the preemptive adjustments of 2023 to a reactive decision-making model based on actual economic data. He emphasized that despite recent soft data such as weak consumer and business confidence indices, the hard data levels of employment, investment, and real consumption performance remain resilient, and the correlation between the two is limited, thus it is unwise to rely solely on sentiment to judge economic turning points.
Regarding the price pressure caused by tariffs, Powell stated that if the impact is a one-time increase in price levels, the Fed will maintain a policy balance between inflation and employment; however, if the price pressure turns into a persistent upward trend, adjustments will be made based on subsequent data. Finally, he emphasized that the current level of interest rates in the economic context is appropriate and is unlikely to change unless there are clear signs that the situation needs adjustment, sending a clear message that there is no urgency to lower interest rates.
SOFR options betting heats up: Traders bearish on the likelihood of rate cuts for the year
In this environment of high uncertainty, market expectations for the timing of rate cuts have also undergone significant adjustments. According to the CME FedWatch tool, as of the meeting, the market's expectation for a rate cut in June has decreased to 17.2%, while the possibility of a rate cut in July has dropped to 51.1%.
Investors generally believe that the Fed will wait for more convincing 'hard data' to verify whether inflation is indeed under control and whether there are signs of economic slowdown before taking further easing actions. Especially under the recent implementation of a new round of tariff policies, the market is also paying attention to their actual transmission effects on the US real economy.
However, the trading behavior in the SOFR options market reflects a more skeptical view of the Fed's rate cut path, with a more pronounced attitude betting that the Fed may not cut rates throughout the year. According to Figure (1), from March 2025, the open interest of SOFR put options has risen rapidly, and in April, a significant increase in trading volume was observed, with daily trading volume also heating up, linked to the December SOFR futures, with a strike price of 95.6875 (corresponding to an interest rate of about 4.31%), which has surged to over 275,000 contracts.
The essence of this strategy is to bet that the Fed will not cut rates by the end of this year, or that the rate cut will be far less than the market originally expected. Since SOFR futures prices have an inverse relationship with interest rates, if future rates are not lowered or even maintained at high levels, then SOFR futures prices may drop below the strike price, leading these put options to enter the money and bring potential profits.
*SOFR: The secured overnight financing rate, an important indicator reflecting the cost of risk-free overnight funds in the US financial market, is often seen as a barometer of interest rate policy expectations.
Figure (1): Market bets on unchanged interest rates – SOFR options open interest surges (Source: Bloomberg)
FOMC maintains balance sheet normalization, market misunderstands short-term bond operations
In this FOMC meeting, the Fed reiterated its continuous push towards balance sheet normalization, with no change in policy stance. The current pace of balance sheet reduction remains at a monthly reduction of $50 billion in US Treasuries and $35 billion in agency bonds and agency mortgage-backed securities (MBS), and has not entered any form of re-expansion or easing cycle.
However, the market has recently misinterpreted the Fed's participation in Treasury auctions. For example, on May 5, the US Treasury auctioned three-year Treasuries, originally intended to issue about $150 billion, but only successfully issued $78 billion. According to Figure (2), the Fed bid through SOMA (System Open Market Account) and was allocated about $20.47 billion in Treasuries. However, this operation led some in the market to mistakenly believe that the Fed had begun implementing quantitative easing (QE) policies.
Figure (2): Results of the US 3-Year Treasury Auction (Source: Department of the Treasury)
In fact, true quantitative easing (QE) operations are carried out by the Fed through expanding the balance sheet and creating bank reserves (i.e., printing money), purchasing long-term Treasuries and agency mortgage-backed securities (MBS) from qualified counterparties in the secondary market. Its main goal is to lower long-term interest rates, increase the lending resources of banks, and stimulate overall economic activity and liquidity in financial markets.
From Figure (3), it can be seen that the Fed's overall balance sheet size does not show signs of recovery or turning upwards; moreover, the target of this purchase is short-term Treasuries, not long-term assets that would be purchased during QE. The most critical point is that the Fed usually purchases assets from the secondary market through open market operations during QE, rather than participating in the Treasury's primary auctions.
Therefore, it can be reasonably judged that this bond purchase is indeed a technical rollover operation, where the Fed reinvests the principal of maturing short-term bonds into newly issued similar short-term bonds, rather than expansive asset purchases, and thus does not change the total asset size or create new reserves, and therefore does not constitute a shift towards a more accommodative policy stance.
Figure (3): Changes in the Fed's Total Assets (Source: FRED)
Summary
The Fed still shows a certain level of confidence in the US economy and continues to observe whether recent soft data will impact hard data. Although uncertainties in trade policy have caused businesses and households to delay investment and consumption decisions, the effects of tariffs have not yet fully manifested in actual economic data.
Recent economic data shows that although the US ISM Purchasing Managers' Index for the services sector remains in expansion, and the number of unemployment claims is stable and at a healthy level, the divergence between hard data and soft data also needs attention. Especially when the Dallas Fed's manufacturing indicators show signs of recession, the market's and the Fed's views seem to differ.
Overall, this FOMC meeting conveyed two core messages: First, the Fed still maintains confidence in the economic fundamentals; second, future policy decisions will be more flexible and will depend on subsequent data, especially in the context where the impacts of tariffs and the lagged effects of transferring global supply chain costs have not fully manifested. These effects may take months to be reflected in the data, particularly concerning the dynamics of stagflation risks and the rebound in inflation.
This report is for informational purposes only and does not constitute any form of investment advice or decision basis. The data, analyses, and opinions cited in this article are based on the author's research and public sources and may be subject to uncertainty or change at any time. Readers should make investment judgments prudently based on their own circumstances and risk tolerance. For further guidance, it is recommended to seek professional advice.