There are signs that traders in the interest rate options market have recently significantly increased their bets on the Federal Reserve cutting interest rates by 50 basis points this month, reflecting growing speculation that policymakers will take proactive action to prevent an economic downturn.
Options linked to the Secured Overnight Financing Rate (SOFR) show a surge in open interest (the number of positions held by traders) in some call option contracts expiring on September 13, five days before the Fed's September rate decision.
If this Friday's non-farm employment report and next week's CPI index indicate that the labor market and inflation are cooling sufficiently to justify a more rapid easing of monetary policy, these positions would pay off.
In fact, there are three major data exams before the Fed's rate cut this month: Wednesday's July JOLTs job openings; Friday's August non-farm employment data; and next Wednesday's August CPI data. After the July JOLTs report, which showed a significant decline in job openings, was released overnight, expectations for a 50 basis point rate cut by the Fed this month have risen rapidly.
The CME Group's FedWatch Tool shows that after the release of the JOLTs report, the chances of a 50 basis point rate cut once jumped to 50%. Although they have gradually fallen back to 45%, they are still significantly higher than the previous day's 38%.
Just one piece of data has already made the probabilities of a 25 basis point and a 50 basis point rate cut almost equal, which undoubtedly makes the suspense around the Fed's rate cut completely unfold before the next two data exams (especially the most important non-farm data).
Priya Misra, portfolio manager at J.P. Morgan Asset Management, said, The labor market has slowed down, and it is now getting the Fed's attention. I see a very strong case for cutting rates initially in 50 basis point increments, given that the funds rate is 5.25-5.5%, the economy is slowing down and the lags between monetary policy and the economy are famously long and variable.
Looking at the performance of the bond market, many traders have apparently prepared for the Fed's continued rate cuts recently. As short-term yields have fallen sharply, the 2-year/10-year Treasury yield spread ended its inversion on Wednesday. J.P. Morgan's survey found that its clients have recently increased their bullish bets on Treasuries and reduced short positions.
In the past twenty years, the Fed has cut rates by 50 basis points or more after the market crash caused by the COVID-19 pandemic, the global financial crisis, and the internet bubble. Of course, at least for now, a similar sense of urgency has not been reflected because the U.S. economy is still growing, and even after a brief decline in early August, U.S. stocks are not much lower than their peaks this year.
However, after Fed Chairman Powell's speech at the Jackson Hole central bank symposium, options trading betting on a 50 basis point rate cut has increased. Compared with several other Fed officials, Powell sounds more willing to take more aggressive measures in the case of a rapid deterioration in the employment situation.
Of course, traders have suffered losses in recent years due to betting too early on the Fed's shift, so many people remain vigilant about the risks. For example, at the end of 2023, the bond market rebounded strongly due to expectations that the Fed would start cutting rates at the beginning of this year, but when the economy showed surprising strength, these gains disappeared.
Jonathan Cohn, head of U.S. interest rate strategy at Nomura Securities, said, The market is split on whether it's going to be 25 or 50 basis points for the inaugural September cut. It almost completely depends on the outcome of the employment report. If certain thresholds are met with respect to the unemployment rate and layoffs, then 50 basis points are absolutely on the table.