Traders start to bet on supersized U.S. Fed rate cut in September

(Bloomberg) — Bond traders are ramping up bets that the Federal Reserve will cut interest rates by half a percentage point in September instead of the standard quarter-point increment.

That’s evident in the federal funds futures market, where softer-than-anticipated inflation data released Thursday morning unleashed a wave of buying of October contracts, which continued on Friday. Expiring Oct. 31, the contracts already fully price in a quarter-point rate cut at policymakers’ Sept. 18 meeting.

Any buying at higher price levels implies an expectation that more people will buy into the idea that the Fed could begin its first easing cycle in years with a supersized move.

“The Fed is very well-placed to potentially cut in September,” said Marilyn Watson, head of global fundamental fixed-income strategy at BlackRock Inc., on Bloomberg TV. While she expects a quarter-point cut, “we think they’ll probably tee things up potentially in July. We know that the Fed has been very, very data dependent.”

The positions would also benefit from an increase in expectations for quarter-point rate cuts on both July 31 and Sept. 18, but traders abandoned hope for a July rate cut weeks ago, and no major Wall Street bank is predicting one.

Futures open-interest data from CME Group Inc. suggest that Thursday’s buying established new risk. Volume was just short of 260,000 contracts, a record for the October tenor. Buying interest remained high on Friday, with volume over 150,000 by 1:30 p.m. New York time

Market-implied expectations for Fed policy were little changed Friday after a report on producer prices had scant impact compared with Thursday’s report on consumer prices.

Swap contracts whose settlement value is determined by the Fed’s policy decisions fully price in a quarter-point rate cut in September and a combined 60 basis points of easing by year-end — implying two quarter-point cuts and 40% odds of a third.

(Adds comment in fourth paragraph, updates volumes in sixth.)

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