Not since the financial crisis have bond traders been so divided over the Federal Reserve’s next policy decision.
With just two days left before the Federal Reserve announces a rate cut, the U.S. interest rate market is arguing over whether it will cut by 25 basis points or 50 basis points. According to data compiled by Bloomberg, this is the most skeptical interest rate swap traders have about any scheduled Fed meeting decision since 2007, except for the Fed's emergency rate cut in March 2020 when the epidemic broke out.
Uncertainty about Fed decisions is at historic highs
The analysis is based on the difference between swap rates and the rate ultimately decided. Fed policymakers are all but certain to cut interest rates this week, their first since 2020. However, before entering a quiet period on Sept. 7, they are weighing whether the risk of further labor market weakness warrants a move of more than a quarter-point, which could reignite inflation.
After several media reports last week quoted former Fed officials as saying that the Fed should take more aggressive rate cuts, market expectations for rate cuts rose sharply. CME's FedWatch showed on Monday that traders believed the probability of the Fed cutting interest rates by 50 basis points this week jumped to 63% from 50% last Friday.
Swaps tied to the Fed's rate decision this week reflect that the Fed will cut the effective federal funds rate from the current 5.3% by 37 basis points, which means that the divergence remains. The market also expects the Fed to cut interest rates by 117 basis points this year, indicating that traders expect the Fed to cut interest rates by 50 basis points at least once this year, if not this week, then in the two remaining meetings in November and December.
Dudley, former president of the New York Fed and a Bloomberg opinion columnist, reiterated his support for a 50 basis point rate cut on Monday. Meanwhile, the Fed's shift comes amid growing political tensions in the United States, with less than two months to go before the presidential election. Three Democratic senators urged the Fed to aggressively cut its benchmark interest rate, including a 75 basis point cut this week, to protect the U.S. economy from potential damage.
The U.S. dollar index fell on Monday, approaching its lowest level of the year, continuing its depreciation trend over the past month as the Federal Reserve's easing cycle approaches. Depending on the scale of the Fed's rate cuts, the dollar could end up weakening further, but this could also be a buying opportunity.
Joe Tuckey, head of foreign exchange analysis at Argentex, a London-based provider of currency risk management and payment solutions, said a bigger rate cut by the Fed this week "will likely push the dollar to new lows," while a smaller 25 basis point rate cut "will likely significantly reduce currency volatility." One reason for his view is that "at its core, the need for a bigger rate cut signals concerns about growth and future economic distress."
Uncertainty is growing about the size of the Federal Reserve’s first rate cut, an unusual development given that officials have struggled in the past to communicate with clarity and that its two-day meeting begins on Tuesday.
"The Fed looks ready to start cutting rates, the main question is whether it will be 25 or 50 basis points," said Mark McCormick, strategist at TD Securities. Speaking about the Fed's interest rate forecasts, the team said, "While the Fed's dot plot and wording should dominate trading around the Fed's policy meeting, we firmly believe that data will be more important than words in the coming weeks and months." The strategists also said the dollar is "closely tracking" U.S. economic growth indicators.
"TD Securities' discussions with clients have typically focused on whether the USD has room to weaken further as the Fed begins cutting rates, or whether this is a buying opportunity as the narrative shifts," McCormick strategists wrote in a note Monday. "We are in the latter camp over the next few months." The firm believes the Fed should start with a 25 basis point rate cut and proceed cautiously.
The article is forwarded from: Jinshi Data