The Fed's 50 basis point rate cut bet this month is over, focus on the dot plot next week

With strong inflation and employment market data reinforcing the cautious action path of the Federal Reserve, the bond market ended speculation about a 50 basis point rate cut by the Fed this month.

Derivatives traders have fully digested the expectation of a 25 basis point rate cut when the Fed announces its policy next week. The U.S. Treasury market closed lower on Wednesday, with selling pressure after the release of inflation data. The S&P 500 index rebounded after a volatile trading day, closing up 1.1%. Stocks closely related to the economy, including equipment leasing companies and heavily indebted small caps, suffered the most during the session but ended higher.

George Catrambone, Head of Fixed Income at DWS Americas, said, "Both the bond market and the Federal Reserve need to see where the economy is heading."

For investors, the biggest puzzle is whether the U.S. economy is heading for a soft landing, requiring a series of mild rate cuts like in 2019 and 1995, or heading for a hard landing at some point next year.

The yield on the policy-sensitive two-year U.S. Treasury initially rose by 9.5 basis points to 3.69%, while the 10-year U.S. Treasury yield rose by 4 basis points to 3.68%. At the close of trading, the front end still maintained an increase of about 5 basis points. "The front end is a sore spot because the market has already priced in so many rate cuts," Catrambone said.

Since July 2023, the Federal Reserve has kept interest rates between 5.25% and 5.5%, and with the easing of inflation pressures over the past 14 months, the restrictiveness of this policy setting has become increasingly apparent. This trend has prompted Fed officials to prepare for a new round of easing starting this month.

"The Fed will start cutting rates, and we will see a 25 basis point cut in September," said Matt Eagan, Portfolio Manager and Head of the Full Discretion team at Loomis Sayles. Once the Fed starts cutting rates, the debate will revolve around the subsequent pace of easing. Fed officials believe that softening in the job market is the catalyst for faster policy relaxation in the coming months. However, a series of weaker-than-expected job reports has not provided a reason for rapid rate cuts.

Eagan expects the Fed to go through a short rate-cutting cycle, eventually lowering rates to 3.5%, rather than the market's current expectation of below 3%. Loomis expects inflation pressures to remain strong due to "structural tailwinds," which mainly include "deficits, aging populations, and geopolitical security concerns."

For traders, the tail risks in the market in the coming months are the performance of the economy and the employment sector. Two monthly employment reports will be released before the Fed announces the results of its November 7 meeting, just 2 days after the U.S. election.

Currently, Fed futures reflect that by the Fed meeting on January 29 next year, the Fed may have cut rates by over 140 basis points, equivalent to two 50 basis point rate cuts in the future four rate meetings if no cuts are made between meetings Bloomberg macro strategist Edward Harrison said, "If the Federal Reserve cannot validate market pricing by forecasting future policy rates through the dot plot next week, yields should rise, and the only factor limiting the rise in yields is the hope and dream of a 50 basis point rate cut in the future due to the upcoming softness in the labor market."

In terms of market fragility, if the Fed's rate cut pace is less than the 250 basis points priced in the September 2025 futures contract, the two-year U.S. Treasury yield may rise.

The strong demand for the $39 billion 10-year U.S. Treasury bonds auctioned on Wednesday reflects investors' interest in current yield bonds. Zachary Griffiths, director of U.S. investment grade and macro strategy at CreditSights, said, "We have never entered the 50 basis point range (for rate cuts), and the slight unexpected rise in CPI seems likely enough to make any policy maker considering larger measures pause."

After the CPI data was released on Wednesday, Citigroup economists abandoned the expectation of a 50 basis point rate cut at the Fed meeting next week, while maintaining the expectation of a total of 125 basis points rate cuts this year. J.P. Morgan still insists that the Fed will cut rates by 50 basis points this month.

Stephen Stanley, chief U.S. economist at Santander Capital Markets, said, "The Fed is very lucky, the CPI data saved them. I doubt that now federal funds futures will fall significantly enough that the FOMC does not need to intervene in market expectations before the meeting." He added that the highly anticipated Jackson Hole central bank economic symposium last month and subsequent Fed official speeches did not provide much guidance on the policy path for the remainder of the year.

David Kelly, chief global strategist at J.P. Morgan Asset Management, told Bloomberg TV after the CPI report was released, "Inflation has now cooled to room temperature, there really isn't a serious inflation problem. The report does not require the Fed to take drastic action, and I would be happy to see a 25 basis point rate cut next week."