US rate futures don't buy into Fed's less-dovish path, price in more 2026 cuts

By Gertrude Chavez-Dreyfuss

NEW YORK, June 23 (Reuters) - U.S. rate futures are pricing in a quicker pace of monetary easing over the next two years than the Federal Reserve penciled in last week in its latest projections, a view cemented after U.S. military strikes on Iran introduced another threat to economic growth.

Traders in futures tracking the Secured Overnight Financing Rate (SOFR), a measure of the cost of borrowing cash overnight, are betting the Fed in 2026 will cut rates more than it anticipated in economic projections released at the close of the central bank's policy meeting last Wednesday.

On Monday, traders' SOFR bets had pushed the implied yield of futures contracts maturing in December 2026 SRAZ26 65 basis points (bps) below those expiring in December 2025 SRAZ25, a record low and the most negative that spread has ever been, suggesting market expectations of more rate cuts. This likely reflects a view that the U.S. economy could hit a deeper slowdown than expected, analysts said.

The trade is used by investors in carry strategies, and while not predictive, it reflects where the market thinks interest rates are headed. The SOFR rate is currently 4.29% USDSOFR=.

"I do think it's definitely an expectation of slowing growth having an impact on Fed policy next year," said Zachary Griffiths, head of investment grade and macro strategy at CreditSights in Charlotte.

"Slowing growth prospects and the effect of all the fiscal and geopolitical uncertainty coming to fruition in 2026...could drive the Fed to ease more."

The rate cuts being priced in SOFR futures are a little more aggressive than the Fed's rate outlook under its so-called "dot plot." The dots show policymakers see rates being reduced by 25 basis points twice this year, from the current target range of 4.25%-4.50%, and only once each in 2026 and 2027.

Market expectations of a steeper rate cut path come even as investors worry that the U.S. attack on Iran's nuclear sites on Saturday could send oil prices LCOc1 much higher, increasing the risk of inflation and further cementing the Fed's wait-and-see stance. Oil prices initially spiked to their highest since January, before paring gains.

But Seth Carpenter, global chief economist at Morgan Stanley, said the supposed pass-through of oil prices is quite modest, at 10%, which historically moves core inflation by only a couple of basis points.

"Even if the national income implications are close to a wash, the distributional effects imply softer consumer spending and thus growth," Carpenter wrote in a research note on Sunday. "Higher oil prices feel inflationary, but they could ultimately mean downside risk for the Fed."

Following the attacks, Morgan Stanley predicted seven rate cuts for 2026.

Fed Chair Jerome Powell has repeatedly cautioned against interpreting the "dots" literally, noting in a press briefing after last week's meeting that "no one holds these rate paths with any conviction."

The sharp rate futures move suggested that traders expect SOFR to dramatically drop next year, in all likelihood due to the Fed cutting interest rates sharply as well. SOFR moves in line with the benchmark fed funds rate, which is tied to monetary policy.

That said, CreditSights' Griffiths pointed out that a 60-bp decline in SOFR hardly screams recession.

DIVIDED FOMC, FED BEHIND THE CURVE?

In keeping rates steady last week, the Federal Open Market Committee cited the potential inflationary impact of U.S. President Donald Trump's tariffs. But it was seemingly divided between one camp that favored rate cuts late this year and another that saw none.

While the median "dot" reflected the rate cut view, analysts said Powell appeared to be on the no-cuts team as he argued at the press conference that he expected the inflationary impact to emerge in the next few months and warned that a cost shock is coming.

Powell said last Wednesday that if not for tariffs, rate cuts might actually be in order, given that recent inflation readings have been favorably low. Powell on Tuesday will deliver the first of two days of congressional testimony on monetary policy, where he will be further quizzed on his outlook.

The Fed expects inflation to end the year at the 3%, way above the 2% target, and some analysts noted that forecast could mean that it could stay put on rates in 2025.

For some market participants, more cuts being factored in next year in SOFR futures suggested that the Fed is well behind the curve and may have to do a lot of catch-up if or when a deep slowdown happens.

Jeremy Siegel, senior economist at WisdomTree Funds in New York, said in a podcast on Friday that the fed funds rate should be 100 bps lower already, in line with what Trump called for.

"You got to look through the tariff bomb," Siegel said. "Obviously there's a range of where tariffs are going to go. But the market has settled down to where it is now, and they think it's going to be nothing worse."