Traders Bet It Will Take Longer for Fed to Start Cutting Rates

The Federal Reserve’s May 2025 decision to hold the federal funds rate steady at 4.25%-4.5% has reshaped trader expectations, pushing the timeline for rate cuts further into 2025—and possibly 2026. While markets initially priced in cuts as early as July, a mix of persistent inflation, labor market resilience, and geopolitical risks has led traders to temper their optimism.

The Fed’s Position: Patience Amid Uncertainty

The Fed’s May meeting underscored its “wait-and-see” approach, with Chair Jerome Powell emphasizing the need to monitor the impact of President Trump’s tariffs on inflation and employment. The central bank’s statement noted that while core inflation has cooled to 2.8% (below its 2022 peak), it remains above the 2% target. Meanwhile, the labor market shows no signs of softening: April’s jobs report added 177,000 positions, keeping unemployment at 4.2%.

The Fed’s reluctance to cut rates is also tied to tariff-related risks. Analysts warn that new 145% tariffs on Chinese imports could fuel price pressures, complicating efforts to balance its dual mandate of price stability and maximum employment.

Market Expectations: Delayed Dovish Turn

Traders have scaled back expectations for an imminent rate cut. As of late May, the CME FedWatch Tool shows:
- 97% probability the Fed will hold rates at 4.25%-4.5% in June.
- 80% chance of a cut by July, down from earlier highs of 60%.
- A 32.1% probability of a year-end rate of 3.75%-4.00%, implying two cuts in 2025.

This reflects a growing recognition that the Fed may wait until late 2025 or early 2026 for clearer evidence of economic slowdown. Goldman Sachs analysts, for instance, now project three rate cuts in 2026, with the first likely delayed until October 2025.

Key Factors Influencing the Fed’s Hand

1. Inflation Dynamics: While goods inflation has eased, services-sector prices (e.g., housing, healthcare) remain stubbornly high. The Cleveland Fed’s tenant rent data shows year-over-year declines, but broader metrics like the core PCE index lag behind.
2. Tariff Fallout: Retailers like Walmart and Target have warned of potential shortages and rising costs due to tariffs. Economists estimate these measures could shave 0.5% off GDP in 2025.
3. Labor Market Resilience: A tight job market has kept wage growth steady at 3.8% year-over-year. Fed officials see this as a positive sign but acknowledge it risks reigniting inflation.

Market Reactions: Volatility Ahead

The delayed rate-cut timeline has already roiled markets:
- Equities: The S&P 500 dipped 0.4% in May as traders reassessed growth prospects. Rate-sensitive sectors like tech (XLK) and real estate (XLK) underperformed.
- Currencies: The U.S. dollar strengthened on reduced cut expectations, with EUR/USD dropping to 1.12 as traders priced in a Fed divergence from the ECB.
- Bonds: The 10-year Treasury yield rose to 4.35%, reflecting diminished near-term easing hopes.

Investment Implications: Positioning for a Slow Pivot

Investors should prepare for prolonged uncertainty:
- Equities: Avoid overexposure to rate-sensitive sectors. Instead, focus on companies with pricing power (e.g., consumer staples) or defensive plays like utilities.
- Fixed Income: Short-term Treasuries remain safer amid volatility. Consider inverse bond ETFs (e.g., TBF) if yields rise further.
- Currencies: A hawkish Fed could boost the dollar, favoring USD-denominated assets. Monitor EUR/USD for a potential breakdown below 1.10.

Conclusion

Traders are now betting that the Fed will delay rate cuts well into 2025—and possibly beyond—to ensure inflation is fully subdued and tariff risks are understood. With a 32.1% chance of a year-end rate of 3.75%-4.00% and the Fed’s emphasis on hard data over sentiment, investors must prioritize flexibility.

The path forward hinges on two key metrics:
1. Inflation: A sustained drop in core PCE below 2% would accelerate cuts.
2. Jobs: A rise in unemployment above 4.5% would force the Fed’s hand.

Until then, markets will remain stuck in a low-growth, high-uncertainty environment—favoring cautious, diversified portfolios over aggressive bets.