In the past three days, the open interest in interest rate futures has surged, and the market is "convinced" that the Federal Reserve will cut interest rates in December. Will the market be wrong this time?
On Tuesday, the yield on the 10-year U.S. Treasury bond fell below 4% during intraday trading for the first time in a month. JP Morgan's client survey this week showed that investors' net long positions in U.S. Treasuries have risen to the highest level in about 15 years. The likelihood of the Federal Reserve cutting interest rates by 25 basis points has risen to about 80%, whereas just a few days ago, this probability was only 30%
Investors are betting heavily that the Federal Reserve will cut interest rates again at next month's meeting.
On Tuesday, the yield on the 10-year U.S. Treasury bond fell below 4% during intraday trading for the first time in a month. JPMorgan's client survey this week showed that investors' net long positions in U.S. Treasuries have risen to their highest level in about 15 years.
(The yield on the 10-year U.S. Treasury bond fell below 4.00% for the first time since Powell's hawkish remarks in October.)
Wallstreetcn mentioned that the news of White House National Economic Council Director Hassett being a popular candidate for the next Federal Reserve Chair has boosted market expectations for lower interest rates in the coming year.
In just a few days, the market's expectations for the Federal Reserve's interest rates have dramatically reversed. The open interest in futures contracts linked to the Federal Reserve's benchmark rate surged over the past three trading days, with the January contract setting a record high for two consecutive trading days last week.
Market pricing shows that traders believe the likelihood of a 25 basis point rate cut next month has risen to about 80%, whereas just a few days ago, this probability was only 30%.
(Green line: Probability of a Federal Reserve rate cut in December vs. Blue line: Probability of a rate cut in January next year.)
Federal Reserve Officials' "Dovish" Tone Drives Market Expectation Reversal
Just a few days ago, the probability of a rate cut in December was only 30%, but the situation has dramatically reversed in a matter of days.
Societe Generale strategist Rajappa stated, that although some officials more concerned about inflation have expressed opposition, Federal Reserve Chair Powell and his allies "support a rate cut." She believes:
Given the recent weak economic data, including the U.S. labor market, Powell will be able to persuade other FOMC members.
Tracy Chen, a portfolio manager at Brandywine Global Investment Management, pointed out:
There is significant disagreement within the Federal Reserve, but it seems that the number of doves outweighs the hawks.
Blake Gwinn, head of U.S. interest rate strategy at RBC Capital Markets, stated:
The market largely viewed (Federal Reserve Vice Chair) Williams' comments as Powell revealing his hand. This week's data also leaned in that direction.
In the past two years, in 20 Federal Reserve meetings, there have only been three instances where traders did not fully digest the results so close to the policy decision.
In the SOFR (Secured Overnight Financing Rate) options market, trading to hedge against a December rate cut has also been unusually active. The open interest for call options related to contracts expiring in December 2025 surged in the past week, with a significant jump in the number of open contracts for options with a strike price of 96.25. This strike price has been used for various hedging structures targeting a 25 basis point rate cut at the December Federal Reserve meeting.
Not Everyone is Convinced a Rate Cut Will Happen
Although market pricing and positioning data overwhelmingly point to a rate cut, not all Wall Street strategists are so certain. In fact, some top investment banks are cautious or even opposed to the idea of a rate cut in December.
Morgan Stanley's strategists canceled their prediction last week that the Federal Reserve would ease policy.
JP Morgan also tends to believe that the Federal Reserve will remain on hold next month, but acknowledges that "the December meeting will still be a very difficult decision." This indicates that even with strong market expectations, the policy outcome remains uncertain.
Tiffany Wilding, an economist at Pacific Investment Management Company (Pimco), stated in a media interview:
We still believe they will cut rates in December, but I think the outlook after that will be more uncertain.
She noted that while the U.S. economy has performed exceptionally well from a growth perspective this year, there are still downside risks in the labor market, and inflation seems to be around 3%, "significantly above the target."
