Investors raise bets on a bumper half-point Fed rate cut

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Investors raised their bets on a half-percentage-point interest rate hike by the Federal Reserve next week, as the U.S. central bank prepares to cut borrowing costs for the first time in more than four years.

Traders in the swaps market are currently pricing in a 47 percent chance that the Fed will opt for a bumper cut so higher rates don't hurt the economy.

On Thursday, they priced in just a 15 percent chance.

Mark Dowding, chief investment officer at RBC Bluebay Asset Management, said a half-point cut was now “very much in play” after being “almost completely priced out” at one point on Thursday.

Markets still attribute a 53 percent chance of a small quarter-point cut, but the likelihood of such a move has fallen significantly since Thursday.

On Thursday evening, the Financial Times and Wall Street Journal reported that the Fed faces a close call on whether to go with a half-point or quarter-point cut.

Former New York Fed President Bill Dudley said Friday he saw a “strong case” for a half-percentage point cut next week, emphasizing the limited impact on raising rates from the current 5.25 percent to 5.5 percent, a 23-year high.

The Fed typically moves in quarterly-point hikes, but the 0.5 percentage point cut could serve as a pre-approved measure if officials think the economy is at risk of slowing too quickly.

Some officials thought the Fed's rate cut at its last meeting in July was “appreciable,” the minutes of that meeting showed, adding that a broader move could help the central bank catch up as inflation has fallen further since then.

“The path of least regret for the Fed is to lead with 50 [basis points]”, said Tim Duy, chief US economist at SGH Macro Advisors. “This is the only logical policy choice.”

At Wednesday's Fed meeting, the last before November's presidential election between Kamala Harris and Donald Trump, officials are highly charged with trying to steer the world's largest economy toward a “soft landing,” where inflation is contained without triggering a recession.

The yield on two-year U.S. Treasury bonds, which track interest rate expectations and move against prices, fell 0.06 percentage points to 3.59 percent on Friday.

Analysts said the meeting was the most uncertain in years, after recent data presented a mixed picture of the economy, with both some residual price pressures and weakness in the labor market.

Figures this week showed that headline inflation eased to 2.5 percent — close to the Fed's 2 percent target — but core inflation rose more than expected to 0.3 percent in the month, partly due to pressure in the housing market.

“If you have lingering residual inflation in the housing and shelter sector, a 50 basis point deficit would likely accelerate or exacerbate it,” said Wylie Tollett, chief investment officer at Franklin Templeton Investment Solutions, who expects a quarter-point cut.

He also said the election could also complicate the case for big cuts.

Trump suggested that a Fed rate cut would help Harris as the current vice-president, “even though it's something they know they shouldn't do”.

Tollette added: “The Fed's path is that they want to do what's right for the economy, but I don't think they're going to cut more aggressively than they think would benefit the incumbent.”

But, with unemployment rising and demand falling, Fed officials want to keep the labor market from weakening further.

Fed Chair Jay Powell said last month that the central bank “will do everything we can to support a strong labor market as we make further progress toward price stability.”

Salman Ahmed, global head of macro at Fidelity International, said: “It's a cat-and-mouse game. . . We have started the cutting cycle, but there is a lot to be determined about it.”

He added that for most of the post-pandemic cycle it “has become abundantly clear that neither the market nor the Fed has any idea what the Fed is going to do”.

Last December, the Fed's forecast indicated a 75 basis point cut during 2024 — but by June it suggested it would make only a quarter-point cut for the year.