Traders Bet Big on Post-Election Fed Rate Cuts as Market Awaits September Decision

Traders in the US interest rate options market remain convinced that the Federal Reserve will need to conduct at least one major rate cut before the year ends. However, expectations have shifted to post-presidential election in early November.

As the Federal Open Market Committee (FOMC) approaches its policy meeting next week, initial views reflected through Fed swap contracts indicate a potential 25 basis-point rate cut, with minimal chance for a larger cut. However, scrutinizing the situation further reveals different possibilities.

Recent options activity tied to the secured overnight financing rate suggests that traders are increasingly positioning for about a 150 basis-point cut by the Fed's January 29 policy decision. This expectation matches the broader sentiment within the swap market.

For this to materialize without inter-meeting cuts, policymakers would need to implement at least two half-percentage-point reductions across four meetings before January. This approach implies cuts more significant than the standard 25 basis points.

Just weeks ago, traders were amplifying bets for a 50 basis-point cut as early as this month due to concerns over a deteriorating labor market, potentially prompting the Fed to act swiftly against recession threats. Subsequent data has somewhat alleviated these worries, yet the anticipation for substantial Fed action remains.

Evidence of a cooling labor market has solidified rate cut expectations, making a September reduction almost a certainty, despite ongoing debates over the magnitude and pace.

September 18 marks a significant meeting where the Fed is expected to enact its first rate cut since 2020, a move already priced into the bond market. The yield on the policy-sensitive two-year Treasury note has fallen from over 5% in April to approximately 3.7%, reflecting market expectations.

Investors are divided: some argue that bond rates have already factored in upcoming Fed cuts, while others believe the Fed's actions might astonish markets, suggesting further upside for bonds. The consensus is that the future of bond prices hinges on the Fed's rate cut trajectory.

As the September Fed meeting approaches, market participants are looking ahead, predicting at least 100 basis points in cumulative cuts by year-end, with some even positing a possible reduction of up to 300 basis points to reach a new equilibrium. This sentiment is shared among different financial institutions and strategists, indicating an ongoing debate over the extent and urgency of forthcoming rate cuts.

Despite elevated unemployment figures, August's nonfarm payrolls report, which showed a modest increase in job numbers and a reduction in the unemployment rate, fueled optimism about the labor market. This mixed data continues to inform the ongoing discourse on whether the Fed will choose to act aggressively or take a more measured approach in its rate adjustments.

The focus also turns to upcoming economic reports, particularly the August CPI report and its implications for the Fed's decision-making process. Observers note that higher-than-expected inflation readings could diminish the probability of major rate cuts.

Overall, traders and analysts are navigating a complex landscape, balancing between economic indicators and anticipation of the Fed's strategic responses. The outlook for Fed policy and its impact on markets remains closely monitored, with pivotal decisions expected in the near term.