Powell may give new hints! Traders are betting on the Fed cutting rates significantly just in case

Bond traders have been preparing for the gradual rate cuts by the Federal Reserve since September, increasing their marginal bets in case a sudden downturn in the US economy forces the Fed to take more aggressive action.

With US Treasury bonds rising for the third consecutive month, investors have fully priced in at least two 25 basis point rate cuts this year, slightly higher than the forecasts of Fed policymakers. In the derivatives market, some traders are even further betting that they will be rewarded if the Fed boldly cuts rates by 50 basis points in mid-September or starts cutting rates earlier.

The market is pricing in more than 2 rate cuts by the Fed this year

While still an outlier, speculation around the need for aggressive measures has gained traction as evidence suggests that businesses and consumers are feeling the pressure of maintaining benchmark rates at two-decade highs. Even as inflation rates ease, investors are increasingly concerned about potential cracks in the labor market, with Fed officials stating they will monitor this.

There is a significant time gap between the policy meetings in July and September, which increases risks.

Jack McIntyre, portfolio manager at Brandywine Global Investment Management, said, "It can be said that if there are more signs of weakness in the labor force, the economic conditions will worsen, prompting the Fed to increase the rate of rate cuts. What we don't know is what kind of rate-cutting cycle this will be."

Last week, former New York Fed Chair Dudley and Mohamed El-Erian suggested that the Fed may have erred by maintaining high rates for too long, with Dudley even calling for action at this week's policy meeting. Both are Bloomberg Opinion columnists. Just this comment alone was enough to stir the markets, causing a so-called steepening pattern in short-term US yields, a common occurrence before an easing cycle.

As rate cuts approach, the US bond yield curve steepens

Nevertheless, data on jobless claims, US economic growth, and consumer spending may still support the Fed's decision to stand pat this week. Michelle Girard, chief US economist at Natwest Markets, said last Thursday that this data "eliminates the urgency for the Fed to act. The Fed doesn't want to appear panicked."

Despite recent election concerns causing some volatility, expectations of imminent rate cuts have boosted the overall trend of US Treasuries, significantly lowering yields from the peak reached at the end of April. The Bloomberg US Treasury Index hit a two-year high this month and is poised for a three-month consecutive rise by the end of July, the last time this happened was in mid-2021 Over the past year, policymakers have kept the target interest rate at 5.25% to 5.5%, while waiting for signs of continued cooling inflation. As prices seem to be moving in the right direction, they have started to pay more attention to the other side of their so-called dual mandate: full employment. Data released last Friday showed the Fed's preferred inflation gauge rising at a moderate pace in June.

Ed Al-Hussainy, global interest rate strategist at Columbia Threadneedle, said that as we wait for rate cuts, the risks are shifting towards the Fed, while Erik Nelson, macro strategist at Wells Fargo, said that if there is no rate cut this week, the U.S. economy will not fall off a cliff.

The next few months are crucial, including this week's employment report.

George Catrambone, head of fixed income at DWS Americas, said that "substantial evidence of weakness could reignite doubts about a soft landing, and the Fed may lag behind the curve, missing the opportunity to cut rates in July."

With expectations that the Fed will stand pat, Powell may raise new economic issues or policy changes at the press conference after this week's decision.

If he lays the groundwork for a larger-than-expected rate cut, it would send a chilling signal: The Fed has only cut rates by 50 basis points twice, in early 2001 after the bursting of the dot-com bubble and in September 2007 during the financial crisis, starting a subsequent period of significant easing.

Michael Feroli of JP Morgan does not expect such a turn. In a note last Friday, he said he expects Powell to "avoid pointing to any specific meeting for the first rate cut." As for questions about not cutting rates this month, Powell may say that officials want further evidence of progress on inflation.

Bloomberg strategist Edward Harrison said, "Dudley recently published a column advocating a rate cut this week, indicating a change in sentiment. Since the resumption of the downward trajectory interrupted last winter, suddenly, people are not concerned about inflation but the rise in the unemployment rate."

George Goncalves, head of macro strategy at MUFG, believes that "there will be more signs of economic weakness by September, which may prompt the Fed to take preemptive action." Goncalves said, "Given the data, the idea of a slow and steady rate cut makes no sense. The longer the wait, the more that may need to be done later."

Some in the market believe that uncertainty is enough to make them hedge their bets. In recent weeks, traders have prepared for their investment prospects using options tied to secured overnight financing rates closely tracking Fed policy expectations, such as betting on a 25 basis point rate cut as early as July or a 50 basis point cut in September. Ed Al-Hussainy, interest rate strategist at Columbia Threadneedle Investments, said, "When a 25 basis point rate cut is fully priced in, you only have two choices. You can either price in no rate cut, or you can price in a 50 basis point rate cut."

Derek Tang, economist at LH Meyer, a Washington policy analysis firm, said that currently, the macro situation does not require or even prove the "reasonableness of rapid easing policies." He said that before attempting drastic measures like a one-time 50 basis point rate cut, officials are more likely to choose to cut rates by 25 basis points at each meeting, i.e. 50 basis points per quarter.

Al-Hussainy said, "From being on hold for over a year to suddenly cutting rates by 50 basis points, it means something has happened, and the situation is not good."