The Fed's Rate-cut Size Debate is Finally Over, Traders Lock in Their Bets

Bond investors, who have been anxiously speculating on the size of the Federal Reserve's first interest-rate cut in four years, are about to discover if their gambles have paid off. The market has largely priced in a quarter-point rate reduction for Wednesday, when the U.S. central bank is anticipated to initiate its rate-cutting cycle. However, the possibility of a larger cut is still seen as a 50-50 chance. This anticipation has driven a rally in Treasuries for the fifth consecutive month, pushing short-term yields—those most influenced by Federal Reserve policy—to their lowest levels in two years.

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The strong enthusiasm for rate cuts has created a risk of significant losses for traders if the Fed opts for a more modest 25-basis-point reduction. Despite the looming uncertainty, futures traders have continued to place record bets on a larger-than-expected cut ahead of the Fed's decision. The upcoming meeting is one of the most unpredictable since 2007, heightening the stakes for market participants.

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George Catrambone, head of fixed income at DWS Americas, commented on the market's current state, stating, "The Fed is going to have to strike some balance here. This is a market that is unbalanced with respect to the amount of rate cuts that they’re pricing in." This sentiment captures the precariousness of the current market environment, where an overly aggressive pricing of rate cuts could lead to volatility if the Federal Reserve's decision falls short of expectations.

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Earlier in September, traders were mostly in agreement on a smaller, quarter-point cut. However, this consensus shifted towards a half-point reduction after reports surfaced that Fed officials were divided on pursuing a more aggressive policy path. Bill Dudley, the former president of the Federal Reserve Bank of New York and current Bloomberg Opinion columnist, added to this momentum by advocating for a 50-basis-point cut, which he believes the Fed will ultimately implement.

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While some analysts and financial institutions back the idea of a more significant cut, only a handful of Wall Street banks, including JPMorgan Chase & Co., are actively forecasting such a move. Others argue that the market may have gone too far in pricing in both this week's potential cuts and those anticipated for the coming year. John Brady, managing director at RJ O’Brien, noted, "It is going to be a close call. The key question is whether the Fed Chair has the full support of his committee for 50 bps of easing."

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Daniel Ivascyn, who manages the world’s largest actively managed fixed-income fund at Pacific Investment Management Co., voiced concerns that the market might be overestimating the extent of rate cuts this year. "The pricing of more than 110 basis points of easing this year looks as if markets may be getting a little bit ahead of themselves in terms of near-term cuts," he said. Consequently, Ivascyn is reducing exposure to short-term notes due in one or two years and shifting his focus toward five-year maturities. This strategy suggests a preference for slightly longer-dated securities in anticipation of potential market corrections.

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Vanguard, one of the world's largest asset managers, is taking a different approach. This week, it is buying the U.S. dollar, based on the view that market bets on Fed rate cuts are excessive. This move indicates a more cautious stance, reflecting the belief that the market may have overreacted to the prospect of aggressive easing by the central bank.

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Beyond the immediate rate cut decision, the market's reaction will also hinge on how Fed officials communicate their outlook for future rate cuts over the next two years, including updates to their dot plot. Additionally, the tone of Fed Chair Jerome Powell’s press conference will be closely scrutinized for clues about the central bank's policy direction. Historically, Treasuries have tended to rally following a Fed decision, with the 10-year benchmark yield having fallen on 17 of the past 20 decision days, declining by an average of 7 basis points. However, stock market responses have been less consistent, with the S&P 500 Index rising only half the time during the same period.

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The two-year Treasury yield, which is particularly sensitive to changes in Fed policy, has dropped from nearly 5% in late April to around 3.5% this week—a low not seen since September 2022. This decline has occurred amid mounting calls for rate cuts against a backdrop of easing inflation and signs of a weakening labor market. Meanwhile, yields on longer-dated Treasuries are mostly trading below 4%.

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Beyond this week's Fed messaging and the upcoming U.S. election in November, a further weakening economy could ultimately validate the current rally in Treasury rates. Sinead Colton Grant, chief investment officer at BNY Wealth, shared her outlook: "The Fed is data-dependent, and our view is that a soft landing is likely. The 10-year yield could go as low as 3%, 3.25% from a couple of weak labor reports and further moderation of inflation."

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As bond investors brace for the Federal Reserve's decision, the stakes are high. The market's current enthusiasm for significant rate cuts could lead to substantial market shifts depending on the Fed's actions and communication. Whether the central bank opts for a quarter- or half-point reduction, the implications for the bond market and the broader economy will be closely watched.

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