Interest rate cut suspense escalates, market divergence intensifies before the Fed's decision

As the Federal Reserve is about to announce its latest interest rate decision, the market has not yet formed a consistent consensus on the extent of rate cuts expected this week. In the recent debate on whether to cut rates by 50 basis points or 25 basis points, the CPI report for August released last week showed that core prices rose more than expected, reducing the possibility of a 50 basis point rate cut. Later last week, traders had diverging views on the extent of rate cuts after media reports that policymakers were still deciding on larger rate cut measures.

Overall, traders are still betting on the possibility of a significant 50 basis point rate cut by the Federal Reserve at the end of this week's meeting. According to the CME FedWatch Tool reflecting trends in the federal funds futures market, the market expects a 61% probability of a 50 basis point rate cut this week on Monday, compared to 50% last Friday and 30% a week ago. There is currently no consensus on a 75 basis point rate cut.

The market expects a total rate cut of about 250 basis points in the next 12 months. The ongoing debate in the market about the Fed's actions on Wednesday indicates that investors expect a significant 50 basis point rate cut this month, totaling 125 basis points for the year.

The level of discrepancy between interest rate decision results and market pricing may be significant

A chart from Deutsche Bank shows that regardless of future trends, the gap between the federal funds rate and market pricing may be the largest in 15 years. If the FOMC cuts rates by 25 basis points, the unexpected expectation for the federal funds in September could be 15 basis points, and if the Fed cuts rates by 50 basis points, it could be -10 basis points; both would be the largest gaps since 2009. The chart shows that current market pricing indicates the Fed will cut rates to near 40 basis points.

Matthew Raskin, head of US interest rate research at Deutsche Bank, said, "We will either see more media-driven information leading the market back to 25 basis points today, or the Fed will ultimately announce 50 basis points on Wednesday."

Kit Juckes, Chief FX Strategist at Societe Generale, stated in a report on Monday that recent US economic data seems to align with the standard of a 25 basis point rate cut by policymakers, but "the only question is whether the market can force the Fed's hand." Juckes pointed out that August retail sales and industrial production data will be released on Tuesday, and the Fed will announce its policy decision this week. Juckes said, "If weak retail sales further push up pricing, if the FOMC fails to meet market expectations for rate cuts, will they worry about 'falling behind the curve'?" Societe Generale economists originally expected a 25 basis point benchmark rate cut Vanda Research forex strategist and senior strategist Viraj Patel said in an article on Monday: "This is not the first time the market has diverged on the issue of a 25-basis-point or 50-basis-point rate cut by the Federal Reserve. The market pricing drifted towards a 50-basis-point cut the day before the meeting. The encouraging part of this story is that regardless of where pricing ends today, the Fed is likely to meet the market."

Wall Street Big Banks Have Different Views

Against this backdrop, Wall Street big banks also have diverging expectations for this week's rate cut.

BlackRock: Expects a 25-basis-point cut

BlackRock Investment Institute stated that the market's expectations for the Fed rate cut seem overly optimistic, as there are still risks of rising inflation. The dynamics of the labor market are key to BlackRock's view.

Jean Boivin, head of BlackRock Investment Institute, said in a weekly commentary: "After the Fed completed its fastest rate hike since the 1980s, the market quickly digested rate cut expectations and digested them as inflation rose. As the Fed prepares to start cutting rates, the market is digesting expectations of a rate cut as large as in past recessions. We believe such expectations are somewhat overdone."

BlackRock stated that the cooling of inflation may be temporary. Boivin said, "The normalization of spending and supply mismatches post-pandemic has essentially ended, and immigration may fall back to historical trends. Once this happens, the economy will not be able to add jobs as rapidly without triggering inflation as it did in the past."

BlackRock mentioned that due to expectations of a significant Fed rate cut, short-term US Treasury yields have fallen, and the company has reduced its bond holdings, noting that the 10-year US Treasury yield hit a 15-month low last week.

Boivin stated that although wage growth has slowed, this is not enough to suggest that core inflation rates may fall to the Fed's 2% target. Additionally, despite recent increases in the unemployment rate raising concerns about an economic recession, employment is still growing. Boivin said, "Supply constraints from massive forces, or structural shifts, will exacerbate global inflation pressures. That's why the Fed and other central banks will maintain high rates for a longer period."

Morgan Stanley: Expects a 50-basis-point cut

The global head of research at Morgan Stanley said that the Fed seems prepared to cut rates by 50 basis points this week, a larger magnitude than the standard 25 basis points, while signaling more easing policies are on the way.

While the market is still debating whether the Fed will cut rates by 50 basis points or 25 basis points on Wednesday, Morgan Stanley's Joyce Chang said that investors she spoke with are more focused on broader economic prospects. Chang said on Monday, "We still stick to the forecast of a 50-basis-point rate cut." She stated that Fed policymakers "now have room to cut rates," and "taking more action may send the right signal."

Chang pointed out that the upward pressure on inflation from the labor market is "diminishing," coupled with the current level of monetary policy constraints, making this week an ideal time for the Fed to cut rates by 50 basis points. The bank's economists currently expect a 50-basis-point cut in November and a 25-basis-point cut in December If the Federal Reserve chooses to cut interest rates by 50 basis points on Wednesday, it will raise questions about the economic outlook. Powell said policymakers are monitoring the slowdown in the labor market.

Chang said: "Our feeling is that the risk of an economic recession—it may occur in the second half of 2025, but it is not imminent now." She said she is not as concerned about the labor market as others because household surveys show that consumer demand still exists, and "there are no massive layoffs" happening. Chang said, "In any case, I think the tone of the Fed this week will be relatively mild."

U.S. officials "petition" the Fed to cut interest rates by 75 basis points

In a more aggressive move, U.S. government officials are calling for a 75 basis point interest rate cut by the Federal Reserve. According to reports, three Democratic senators, Elizabeth Warren, Sheldon Whitehouse, and John Hickenlooper, wrote to Fed Chair Powell and other relevant policymakers advocating for a 75 basis point rate cut to protect the U.S. economy from potential recession.

The three senators stated in the letter: "If the Fed is too cautious in cutting rates, our economy could slide into recession, which is unnecessary." The letter was sent a few days before this Wednesday's interest rate decision.

Warren, Whitehouse, and Hickenlooper added, "Now is the time to cut rates quickly," because "job data adjustments are slow, so the Fed should cut rates in advance to avoid sliding into a potential crisis."

The senators expressed their concerns about the latest employment data, believing that "it is clearly time for the Fed to cut rates," and went on to say: "In fact, it may already be too late: your delay has threatened the economy, leaving the Fed behind the curve."

It is worth noting that while Federal Open Market Committee officials have recognized that the labor market is cooling, they still believe the current employment environment is stable. In response to this letter, a Fed spokesperson said: "We have received this letter and plan to respond."