From the perspective of market expectations, tonight will undoubtedly be the most stimulating Federal Reserve interest rate night in the past decade. With the expectation of a 50 basis point drop by the Federal Reserve at this meeting rapidly heating up in the past few trading days, a large number of market participants have also placed bets on the Fed's potential large-scale actions. And a serious risk caused by this is:
If Federal Reserve officials "unexpectedly" choose to use the standard approach (a 25 basis point rate cut) to kick off the easing curtain, then those fixed income traders who made record breaking bets may face huge losses.
According to industry aggregated data, the number of open contracts for October federal funds futures that investors use to bet on this week's Federal Reserve interest rate meeting has jumped to its most extreme level since the derivative was introduced in 1988.
And most of these new bets are on the Federal Reserve cutting interest rates by 50 basis points this month, with a particularly significant surge in related positions since the beginning of this week - new positions in the past two trading days accounted for almost one-third.
In the futures market linked to the Guaranteed Overnight Financing Rate (SOFR), a new massive trade emerged during Monday's trading session, with trading targets similar to betting on a 50 basis point rate cut by the Federal Reserve this month.
Currently, with the Federal Reserve almost certain to cut interest rates this week, the debate among investors is mainly focused on the magnitude of the first rate cut.
Although the mainstream consensus in the market at the beginning of last week was that the Federal Reserve would first choose to cut interest rates by 25 basis points, there has been a major change in market expectations in recent days - especially after renowned journalist Nick Timiraos, known as the "New Federal Reserve News Agency," repeatedly stated that "the magnitude of the first interest rate cut is still uncertain," and senior figures such as former New York Fed President William Dudley called on Fed decision-makers to take more aggressive action, the possibility of a 50 basis point rate cut has actually taken the upper hand at present.
According to the "Federal Reserve Watch Tool" of Zhishang Institute, traders in the interest rate futures market currently expect a 64% probability of the Fed cutting interest rates by 50 basis points tonight, while the probability of a 25 basis point rate cut has decreased to 36%.
Behind the rapid pace of a 50 basis point interest rate cut, people have even completely ignored last night's better than expected US retail sales data. The data released by the US Department of Commerce on Tuesday showed that the monthly retail sales rate in August recorded 0.1%, exceeding the expected -0.2%, and the previous value was revised up from 1% to 1.1%. The data suggests that the US economy maintained steady growth for most of the third quarter.
Obviously, in the context of the Fed's "quiet period" (without any Fed officials speaking out) and economic data not entirely favorable for a 50 basis point rate cut, market expectations have undergone such a dramatic change in just a few trading days, which is unprecedented.
Is there a huge market risk tonight?
Behind this, on the one hand, people may once again marvel at the great influence of some media outlets as the "mouthpiece" of the Federal Reserve, while on the other hand, it undoubtedly indicates that tonight's market situation may face huge risks.
According to industry compiled data, apart from the Federal Reserve's emergency interest rate cut during the outbreak of the pandemic in March 2020, this meeting will be the most "confusing" for interest rate swap traders to make decisions on interest rates since 2007. Mark Chandler, Chief Market Strategist at Bannockburn Global Forex, pointed out that such evenly matched bets are rare before the Federal Reserve meeting.
Bespoke Investment Group strategists also stated that during Powell's tenure at the Federal Reserve, it is rare for the market to remain so "ambiguous" about what actions the Fed will take just one day before the decision day. Although the Federal Reserve may be satisfied with the market's 100% confidence that it will cut interest rates.
In the bond market, the recent sharp rise in the price of US bonds under the expectation of interest rate cut has pushed the yield down significantly. The yield of US two-year treasury bond bonds hit a two-year low of 3.52% this week.
Subadra Rajappa, head of US interest rate strategy at Soci é t é G é n é rale, said that this could lead to significant selling pressure in the market given the small magnitude of the Fed's rate cuts and Powell's gradual signals. If the Federal Reserve cuts interest rates by 25 basis points instead of 50 basis points, the market reaction will be much stronger, and statements such as position allocation, optimism, and a more relaxed financial environment may be tested
Kathy Jones, chief fixed income strategist of Credit Suisse Financial, said that short-term US treasury bond bonds are more sensitive to the Federal Reserve's policy, and they may suffer the biggest impact, especially considering that the market "pricing has been quite radical", "If the Federal Reserve finally cut interest rates by only 25 basis points, as a preliminary response, you can easily see the yield rebound by 10 or 15 basis points."
A survey conducted by 22V Research before this week's Federal Reserve decision showed that investors who expected the Fed to cut interest rates by 25 basis points this week had divergent expectations about whether the rate cut would bring about a "risk on" or "risk off" market reaction. At the same time, investors who expect the Federal Reserve to significantly cut interest rates by 50 basis points believe that if the Fed's rate cut is small, it will trigger a market "safe haven" action.
Steve Sosnick, Chief Strategist at Interactive Brokers, still believes that the Federal Reserve should lean towards 25 basis points, but he points out that years of trading experience have taught him to respect the information released by the market. He said, "Recent market information has been saying that there will be a 50 basis point interest rate cut
Sosnick pointed out that if the Federal Reserve ultimately chooses to cut interest rates by 25 basis points, the market may generally feel disappointed. The stock market always desires more liquidity, while the bond market has almost digested the expectation of a significant interest rate cut in future meetings. Therefore, a smaller rate cut would be detrimental to both parties.