On the eve of the non-farm payroll showdown, Citigroup and Morgan Stanley continue to bet that the Federal Reserve will cut rates by 50 basis points in September!

Citigroup and JPMorgan Chase and other companies boldly bet that the Federal Reserve will cut interest rates by 50 basis points this month, but this bet will face a test from the US non-farm payroll report released on Friday.

Interest rate swap contracts show that the probability of the Federal Reserve cutting interest rates by 50 basis points at the meeting on September 17th to 18th is about 35%. Traders still prefer the Federal Reserve to cut interest rates by 25 basis points, which is also a more common view among economists.

This divergence has intensified significant volatility in the US Treasury market before and after the release of the non-farm payroll report. Last month's employment data came in below expectations, leading to market turmoil.

Matthew Raskin, Head of US Interest Rate Research at Deutsche Bank, said, "There is a lot of uncertainty in the market, and it is expected to be resolved this week."

Federal Reserve Chairman Powell has placed the labor market at the core of the Federal Reserve's decision on when and at what pace to ease monetary policy. Soft job vacancy data in July, as well as lower-than-expected ADP private sector employment growth data earlier on Thursday, have increased market expectations for a significant interest rate cut by the Federal Reserve.

The day after the employment report is released, the Federal Reserve will enter its customary blackout period, during which the Federal Reserve will refrain from commenting on policy before the meeting.

According to Deutsche Bank's data, over the past 15 years, at the start of the blackout period, there has typically been only a 3 basis point difference between the implied expectations in swaps and the Federal Reserve's final policy decision. Currently, the market is pricing in a 34 basis point easing, which means there will be significant volatility in swaps this week, either dropping to at least 28 basis points or rising to 47 basis points or higher—if the data clearly supports a 25 basis point or 50 basis point rate cut.

Alex Manzara, Derivatives Broker at R.J. O'Brien & Associates, said, "There is a lot of uncertainty in the market regarding the employment report, the stock market, and what actions the Federal Reserve will take." Since late July, the S&P 500 index has fallen by more than 2% three times.

Manzara stated, "The pricing levels of options on US two-year Treasury futures indicate that the US bond yields are expected to fluctuate by about 17 basis points in both directions on Friday."

Meanwhile, David Robin, Interest Rate Strategist at TJM Institutional Services LLC, said, "The pricing of overnight financing rate futures (overnight rates influenced by Federal Reserve policy rates) shows a stronger confidence that the Federal Reserve will choose to cut rates by 50 basis points."

In addition, foreign exchange traders have been more active than over a year ago before the release of the US employment report. Options measuring the volatility of the US dollar against major trading currencies reached the highest level since March 2023 on the eve of the key non-farm payroll data release. The so-called risk reversal shows a bearish sentiment towards the US dollar, while some traders are completely avoiding short-term bets due to uncertainty Institutions pointed out that "Friday's non-farm payroll report is so important to the market, in part because the bond market tends to expect the Fed to either start the upcoming easing cycle by cutting rates by 50 basis points, or to cut rates shortly after the easing cycle begins. Looking back at the history of Fed rate cuts, it can be seen that bond bulls may be chasing the rally excessively."

Since the release of the weak July employment data on July 2 by Citigroup and JPMorgan Chase, they have been expecting the Fed to cut rates by 50 basis points in September and November, as well as 25 basis points in December. At that time, JPMorgan Chase economists even stated that there is a strong case for the Fed to act before September 18, which would be the first inter-meeting rate cut by the Fed since March 2020.

The market is in line with their views, with pricing indicating a drop of nearly 125 basis points by the end of the year, reflecting widespread selling. However, expectations for Fed rate cuts this year have since decreased due to strong retail sales and a decline in jobless claims. The swap market currently indicates a cut of about 110 basis points by the Fed this year - a figure that still suggests the Fed will need to cut rates by at least 50 basis points at one meeting.

Citigroup and JPMorgan Chase have recently moderated their views but have not changed their forecasts. Citigroup stated that if the U.S. unemployment rate drops from 4.3% to 4.2% in August, the Fed may only cut rates by 25 basis points, "unless wage growth also weakens." JPMorgan Chase said that a 50 basis point cut "will to some extent depend on the August employment report".

Raskin pointed out that if the employment data fails to lock in a 25 or 50 basis point rate cut by the Fed in September, the August CPI data released on September 11 may still provide guidance. But if this fails to influence market direction, policymakers may break their silence and hint at their intended actions. He added:

"The Fed does not like to surprise the market at policy meetings."