Traders increase bets on a 25 basis point rate cut next month, facing two more "data bombs" tonight

Due to the continuous decline in US inflation, bond market investors have strengthened their bets on a 25 basis point rate cut by Federal Reserve officials in September.

Overall, traders on average expect a 32 basis point rate cut at the September Fed meeting, down from the previous day's expectations, and have reduced the probability of a 50 basis point rate cut to about one-third. US Treasury bonds mostly rose on Wednesday, pushing the 5-year bond yield to lower levels.

Traders expect the Fed to cut rates by almost 25 basis points next month.

David Kelly, Chief Global Strategist at J.P. Morgan Asset Management, said in a TV interview that the inflation data released on Wednesday was weakening, "confirming that the inflation issue is fading. The CPI data meeting expectations is an example of selling the news - this is happening in the bond market."

On Wednesday, the policy-sensitive 2-year US Treasury bond yield rose to 3.95%, while the 5-year bond yield steadily declined, with the 30-year bond yield dropping by 4 basis points. Open interest, the risk taken by futures traders, aligns with the profit positions of bond traders in the US Treasury market. Data released on Tuesday showed that the July Producer Price Index (PPI) increase was lower than expected, increasing their bullish bets.

In Wednesday's trading, options related to the Secured Overnight Financing Rate (SOFR) reflected that traders are unwinding their bets on a 50 basis point rate cut. SOFR closely follows the Fed's policy path. Traders seem to be adjusting other dovish bets, as the pricing in the swaps market tends towards a 25 basis point rate cut rather than a 50 basis point cut. Before making these adjustments, the so-called core CPI (excluding food and energy costs) in July grew by 3.2% year-on-year, still the slowest pace since early 2021. This largely aligns with economists' expectations, keeping the Fed on track for an imminent rate cut.

Traders bet on further gains in US bonds, with open interest in 10-year US bonds nearing record highs.

Traders still expect the Fed to cut rates by slightly more than 1 percentage point by 2024, with three policy meetings remaining this year. In recent trading days, market pricing has shown a divergence in expectations for a 25 basis point or 50 basis point rate cut next month.

More Insights from Wall Street Professionals

Lindsay Rosner, Head of Multiple Fixed Income Departments at Goldman Sachs Asset Management, stated that the CPI data "cleared the way for a 25 basis point rate cut in September, but did not completely rule out the possibility of a 50 basis point cut." **The weekly initial jobless claims and retail sales data to be released on Thursday will provide traders with the next clue, as they focus on the extent of future easing They will also carefully study the remarks of Federal Reserve Chairman Powell at the annual central bank symposium in Jackson Hole, Wyoming later this month, as well as the next U.S. employment report in early September.

Neil Sutherland, portfolio manager at Schroder Investment Management, said at the Jackson Hole central bank annual meeting, "They may refuse to acknowledge more negative growth prospects." "We do see a softer job market," he said. With discussions in the market about the extent of a possible rate cut by the Federal Reserve in September, "the labor market will give us more clarity."

Chris Larkin of Morgan Stanley E*Trade said, "It may not be as cool as yesterday's (Tuesday) PPI, but today's CPI, as expected, may not upset the status quo. The main issue now is whether the Federal Reserve will cut rates by 25 basis points or 50 basis points next month. If most of the data in the next five weeks points to an economic slowdown, the Federal Reserve may cut rates by a larger margin."

Krishna Guha of Evercore stated that while CPI is not perfect, it is good enough as it aligns with the moderate reading of the inflation gauge preferred by the Federal Reserve. In addition, the Federal Reserve has abandoned its reliance on data points and is focusing on a broader outlook and risk balance. He noted, "The current Federal Reserve is one that prioritizes employment data, not inflation data, and future employment data will determine the extent of rate cuts by the Federal Reserve."

Mark Hackett of Nationwide stated that "easing macro concerns" is one of the factors contributing to the improved backdrop of the stock market. He pointed out that the pressure of market declines is a "gradually fading memory."

Strategists at TD Securities led by Oscar Munoz and Gennadiy Goldberg stated that the latest CPI report provides conditions for the Federal Reserve to start cutting rates in September.

For Chris Zaccarelli of Independent Advisor Alliance, the July CPI data is "no news is good news" as the market has been tense and the Federal Reserve is seeking rate cuts - nothing in this report should stop them from doing so.

Seema Shah of Principal Global Investors stated that the CPI data removes any lingering inflation barriers that may have hindered the Federal Reserve from starting a rate cut cycle in September. However, this number also indicates that the urgency for a 50 basis point rate cut is limited.

Florian Ielpo of Lombard Odier Investment Managers said, "Apart from potentially supporting a rate cut due to concerns about the job market, it (CPI) has provided almost no new information to guide the Federal Reserve's future decisions." Bloomberg Economics' Anna Wong and Stuart Paul said, "A soft CPI report may slightly strengthen Fed officials' confidence that inflation is falling. Although July's core Personal Consumption Expenditures (PCE) inflation data may not be as good, we expect the Fed to cut rates in September due to the rise in unemployment."

Brian Rose from UBS Global Wealth Management stated, "Inflation data has been good enough to prompt the Fed to start cutting rates in September, but it hasn't given them a strong reason for a significant rate cut. Whether to cut rates by 50 basis points instead of the usual 25 basis points may depend on the August employment report."

Rose also pointed out that Thursday's retail sales data is another key data point, as a major downside risk to his soft landing base case is a decline in consumer spending.

Neil Sun, portfolio manager at BlueBay Asset Management, a subsidiary of Royal Bank of Canada, said, "The U.S. economy is continuing to cool down, and there have been some signs of a slowdown in the labor market. However, we are not overly concerned about the risk of a recession in the U.S. in the short term. If the potential trends of cooling inflation and continued economic slowdown in the U.S. persist, we are ready to take advantage of any fluctuations at any time."