Traders Struggle to Find Conviction on Size of Fed’s Rate Cuts

(Bloomberg) -- Investors in the US Treasury market are divided on whether the Federal Reserve will opt for a supersized interest-rate cut later this month.

With a mixed US labor report for August failing to send a clear message, traders are pricing in a less than 20% chance that officials lower rates by half a percentage point in September after data showed job creation slowed in August and US policymakers backed the case for easing. 

Treasuries rose on Friday, pushing the yield on two-year notes — which are more sensitive than longer maturities to changes in the Fed’s policy outlook — lower by as much as 11 basis points to 3.63%.

“It is difficult to handicap exactly how much the Fed will cut at each meeting, but the direction of travel is clear,” said Gene Tannuzzo, global head of fixed income at Columbia Threadneedle. 

Traders were seeking guidance from the August employment report, which showed job creation slowed. Prior months were also revised lower and the unemployment rate fell.

Treasuries flip-flopped Friday in the wake of the report that was followed by comments from New York Fed President John Williams, Fed Governor Christopher Waller and Chicago Fed President Austan Goolsbee. 

All three said it’s time to begin cutting rates, with Waller taking it a step further by noting that he’s “open-minded” about the potential for a bigger rate cut and would advocate for one if appropriate.

When the dust settled, swaps traders priced in about 29 basis points of rate reduction by the Fed this month. For all of 2024, the contracts now imply about 109 basis points of reductions — just slightly up from around 108 basis points earlier in the session.

“The market is ‘only’ pricing the Fed to reach a longer-run ‘neutral’ rate of around 3%,” said Tannuzzo. “The market is still not pricing them to reach an accommodative stance. Whether or not an accommodative stance is warranted will depend on the labor market and how quickly further deterioration is realized.” 

Despite expectations that the labor reading would clearly cement the case one way or another on the size of the Fed’s widely-predicted rate cuts it failed to do so. The lack of conviction sets the stage for a few weeks of out-sized volatility in the Treasury market, as history shows that the pricing of rate reduction is typically solidly above or below 50% for the specific Fed action ahead of policy meetings.

The “tricky” jobs report left “investors guessing if the Fed will cut by 25 basis points or 50 basis points at the September FOMC meeting,” Subadra Rajappa, head of U.S. rates strategy at Societe Generale, said.

Only a strong jobs report could have stalled this rally and this is not that report, she said, adding that the asymmetric reaction in bonds continues with more cuts getting priced in and sooner.

What Bloomberg Strategists Say...

“There’s very little chance that the Federal Reserve is cutting by 50bps on September 18th based on a 4.2% unemployment number. Yet the bond market saw the two year yield down. The takeaway, then, is that the pricing for Treasury yields out to two years is very rich and we’re likely to see yields rise from here when reality seeps in.”

—Edward Harrison, MLIV reporter

Next week, reports on both consumer and producer prices in August are slated. All of which could set the market up for continued volatility, with Fed officials going into their pre-meeting blackout period over the weekend.

“I’ve been in the camp they shouldn’t go 50 they should go 25. Now I see an over 50% chance they go 50 basis points if consumer price index next week is tame,” said Tony Farren, managing director in rates sales and trading at Mischler Financial Group, adding that it opens up the possibility of a 50 basis point cut.  

George Goncalves, head of US macro strategy at MUFG, also predicts a 50-basis point rate reduction this month.

“The reality is that since April job growth is decelerating,” said Goncalves. “They are behind the curve. The longer they wait worse it gets.”

--With assistance from Michael Mackenzie and Edward Bolingbroke.

(Updates with more details and comments throughout.)

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