The most confusing Federal Reserve meeting since the financial crisis! Will the US dollar make a comeback?
The Federal Reserve is about to hold a meeting, and the market has a serious divergence on the magnitude of the interest rate cut, with expectations of a 25 or 50 basis point cut. Analysis shows that the uncertainty of the Fed's decision has reached a historical high, and traders' expectations of a rate cut have significantly increased. The former president of the New York Fed supports a 50 basis point cut, while three Democratic senators are calling for a 75 basis point cut to protect the economy. The US dollar index has fallen due to expectations of a rate cut, approaching its lowest level of the year
Since the outbreak of the financial crisis, bond traders have never had such a serious difference of opinion on the next policy decision of the Federal Reserve.
With only two days left until the Fed announces a rate cut, the U.S. interest rate market is divided on whether it will cut rates by 25 basis points or 50 basis points. According to data compiled by Bloomberg, apart from the emergency rate cut by the Fed in March 2020 when the epidemic broke out, this is the biggest doubt among interest rate swap traders about any scheduled Fed meeting decision since 2007.
Uncertainty about Fed decisions is at a historical high
This analysis is based on the difference between swap rates and the final decision rate. Fed policymakers are almost certain to cut rates this week, marking their first rate cut since 2020. However, before entering the blackout period on September 7, they evaluated the risk of further weakness in the labor market and whether it was necessary to take measures to cut rates by more than 25 basis points, which could reignite inflation.
Last week, several media reports quoted former Fed officials as saying that the Fed should take more aggressive rate cut actions, leading to a significant increase in market expectations for rate cuts. On Monday, CME's FedWatch showed that traders believe there is a 63% probability that the Fed will cut rates by 50 basis points this week, up from 50% last Friday.
The pricing of swaps linked to the Fed's rate decision this week reflects that the Fed will cut the current effective federal funds rate of about 5.3% by 37 basis points, indicating that differences still exist. The market also expects the Fed to cut rates by 117 basis points this year, indicating that traders expect the Fed to cut rates by at least 50 basis points this year, either not this week, or in the remaining two meetings in November and December.
Former New York Fed Chairman and Bloomberg Opinion columnist Dudley reiterated his support for a 50 basis point rate cut on Monday. Meanwhile, the Fed's shift comes against the backdrop of an increasingly tense U.S. political situation, with less than two months until the presidential election. Three Democratic senators urged the Fed to actively lower benchmark rates, including cutting rates by 75 basis points this week, to protect the U.S. economy from potential harm.
As the Fed's easing cycle approaches, the U.S. dollar index fell on Monday, nearing its lowest level of the year, continuing a month-long depreciation trend. Depending on the size of the Fed's rate cut, the dollar may weaken further, but this could also be a buying opportunity.
Joe Tuckey, FX analysis director at London-based currency risk management and payment solutions provider Argentex, said that a larger rate cut by the Fed this week "is likely to push the dollar to new lows," while a small 25 basis point rate cut "could significantly reduce currency volatility". One reason he holds this view is that, "fundamentally, the necessity of a larger rate cut reflects concerns about growth and future economic difficulties" The uncertainty surrounding the size of the Fed's first rate cut is increasing. Considering that officials have been working hard to communicate clearly in the past, and their two-day meeting is set to begin on Tuesday, this is an unusual development.
Mark McCormick, a strategist at TD Securities, said, "The Fed appears ready to start cutting rates, the main issue is whether the rate cut will be 25 or 50 basis points." When discussing the Fed's rate forecasts, the team stated, "While the Fed's dot plot and language should dominate trading around the Fed's policy meeting, we firmly believe that data will be more important than words in the coming weeks and months." These strategists also noted that the dollar is "closely tracking" U.S. economic growth indicators.
In a report on Monday, McCormick and his team wrote, "Discussions between TD Securities and clients often focus on whether the dollar will soften further as the Fed begins to cut rates, or whether this is a buying opportunity as the narrative shifts. In the coming months, we are in the latter camp." The company believes that the Fed should start with a 25 basis point rate cut and proceed cautiously