Goldman Sachs research report recently pointed out that the financial markets are overly optimistic about the extent of rate cuts by the Federal Reserve next year, which provides an opportunity for options traders to profit from betting against it.
Strategists including Praveen Korapaty wrote in a recent report that the market expects a 125 basis point rate cut by the Fed over the next 12 months, with a 50 basis point cut before the end of June (indicating that the US economy is on the brink of recession). This is much more aggressive than Goldman Sachs’ own forecast, which predicts only one rate cut of 25 basis points in 2024.
They stated, “The market is approaching its limit in terms of pricing reasonably without taking into account recent possibilities of economic recession.”
Goldman Sachs strategists recommend selling SOFR 95.25 call options expiring in June 2024 and betting against previous expectations for accelerated rate cuts. SOFR options are linked to secured overnight financing rates, which closely track market expectations for Fed policy paths. The option will expire on June 14th next year, two days after the central bank’s policy statement in June.
In recent trading days, traders have been increasing their pricing for rate cuts next year in futures, options, and spot markets. Data released last Friday by Commodity Futures Trading Commission showed leveraged net positions on SOFR futures reaching new highs.
In addition, there have been bets in the options market targeting up to a maximum reduction of 250 basis points before September next year, about 150 basis points higher than current pricing in swap markets.
Goldman Sachs economists only expect one rate cut by the Fed in 2024 and most likely during Q4. However, there are significant differences among major Wall Street banks’ expectations; for example UBS expects multiple rate cuts.
According to CME’s FedWatch tool as of press time, traders believe that five rate cuts by the end of 2024 are the most likely scenario.
However, the Goldman Sachs Korapaty team believes that even if the Fed’s rate cuts exceed their economists’ expectations, it is unlikely that the currently expected scenario of five rate cuts will occur.