Traders Bet on Fed Rate Cuts of 50 Basis Points as Treasury Yields Slip

U.S. government debt surged on Friday morning, pushing yields down to some of the lowest levels seen in 2023. This rally came as traders assessed the possibility of a significant Federal Reserve rate cut, one that could be the largest since the 2008 financial crisis, potentially arriving next week.

‍

What’s Happening:

The 2-year Treasury yield dropped by 7.4 basis points to 3.573%, down from 3.647% on Thursday. Similarly, the 10-year Treasury yield fell by 2 basis points to 3.659%, from its previous level of 3.679%. Meanwhile, the 30-year Treasury yield dipped by less than 1 basis point to 3.991%, compared to 3.996% a day earlier.

‍

What’s Driving the Markets:

Traders in the Fed-funds futures market were pricing in the possibility of a 50-basis-point rate cut at the Federal Reserve’s upcoming meeting next Wednesday. According to the CME FedWatch Tool, the probability of such a rate cut stood at almost 50% by Friday morning, with the odds of a 50-basis-point cut at 47% and the likelihood of a smaller 25-basis-point cut at 53%.

‍

Fueling expectations for a more significant rate cut were reports from major financial publications such as The Wall Street Journal and Financial Times. These reports indicated that Federal Reserve officials were grappling with how aggressively they should lower interest rates to address potential economic concerns. Additionally, Bill Dudley, former President of the Federal Reserve Bank of New York, published an opinion piece in Bloomberg arguing that the weakening labor market posed a risk to the U.S. economy. Dudley’s article supported the case for a 50-basis-point cut, given the current economic environment.

‍

Gary Pzegeo, head of fixed income at CIBC Private Wealth US, which manages approximately $107 billion in assets, commented on the situation. According to Pzegeo, the central debate ahead of next week’s Federal Reserve meeting revolved around whether the Fed would opt for a 25-basis-point or a 50-basis-point cut. He explained that a larger 50-basis-point cut would signal a more aggressive approach, one typically seen during times of recession or financial market crises.

‍

In an email statement, Pzegeo noted that a 50-basis-point reduction would align more closely with the kind of rapid response measures the Federal Reserve has historically implemented in periods of severe economic downturns or financial instability. However, he also indicated that the more likely scenario is that the Fed will start its easing cycle with a smaller, 25-basis-point cut, which he referred to as the "normal" response.

‍

The Impact of a 50-Basis-Point Cut:

If the Federal Reserve does opt for a larger 50-basis-point rate cut, it could have significant implications for both the bond market and the broader economy. A larger rate cut would signal that the Fed is deeply concerned about the economic outlook and is willing to take bold steps to support growth. This could lead to further declines in bond yields, as investors seek safety in U.S. government debt, which typically benefits from lower interest rates.

‍

At the same time, a more aggressive rate cut could help stimulate economic activity by lowering borrowing costs for businesses and consumers. This would make it cheaper for companies to finance new projects and for individuals to take out loans for homes, cars, and other big-ticket purchases. However, the downside of such a move is that it could also signal a deteriorating economic environment, which might spook investors and lead to increased volatility in financial markets.

‍

Why the Labor Market Matters:

One of the key factors influencing the Fed’s decision-making is the health of the U.S. labor market. The central bank has consistently monitored employment data to assess whether the economy is overheating or slowing down. A weakening labor market, characterized by rising unemployment or slower job growth, could push the Fed to cut rates more aggressively to prevent a further downturn.

‍

Bill Dudley’s Bloomberg column highlighted this concern, pointing out that the U.S. labor market has shown signs of softening. While the overall job market remains relatively strong, there are indications that growth is slowing, which could raise concerns about the broader health of the economy. Dudley argued that these risks justify a more aggressive approach from the Federal Reserve, including a 50-basis-point rate cut.

‍

A Conservative Approach Still Likely:

Despite the arguments in favor of a larger rate cut, many analysts and market participants believe that the Federal Reserve will take a more cautious approach by cutting rates by 25 basis points instead. This would mark the beginning of an easing cycle aimed at gradually reducing borrowing costs and supporting the economy without overreacting to current conditions.

‍

A smaller, 25-basis-point cut would allow the Fed to assess the impact of its actions before making further adjustments. It would also signal to the markets that the central bank is not panicking, but rather taking a measured approach to managing economic risks. Additionally, such a move would give the Fed more flexibility to cut rates further if necessary, without exhausting its options too quickly.

‍

Conclusion:

As U.S. government debt yields hit some of their lowest levels of the year, the bond market is clearly anticipating action from the Federal Reserve. Whether the Fed opts for a 25-basis-point or 50-basis-point rate cut, the outcome will have significant implications for the broader economy and financial markets. While some experts, like Bill Dudley, argue for a larger cut to address risks in the labor market, others, like Gary Pzegeo, believe a more cautious approach is likely. Either way, next week’s Fed meeting is expected to be a pivotal moment for both the bond market and the economy as a whole.

‍