Bond traders who have been intensely speculating on the size of the Federal Reserve’s anticipated rate cut are about to see if their bets pay off. The market is now fully pricing in a quarter-point rate reduction as the central bank is expected to kick off a new rate-cutting cycle. However, there remains a nearly equal chance that the Fed may opt for a more significant move.
Treasuries have experienced a steady rally leading up to this decision, marking their fifth consecutive month of gains. This momentum has driven short-term yields—the ones most sensitive to Fed policy—to their lowest levels in two years. However, this optimism also introduces a risk: if the Fed goes for a modest 25-basis-point cut instead of a larger reduction, traders could face significant losses.
Despite the uncertainty surrounding this Fed meeting—the most unpredictable since 2007—futures traders have doubled down, increasing their record number of bets on a more substantial cut. As investors await the Fed’s decision at 2 p.m. in New York, Treasury yields edged slightly higher, with the two-year yield rising by 5 basis points to 3.66%.
“The Fed needs to strike a balance,” said George Catrambone, head of fixed income at DWS Americas. “The market is heavily tilted towards multiple rate cuts, which may not align with what the Fed has in mind.”
Earlier in September, the consensus among traders leaned towards a smaller quarter-point cut. However, recent reports suggesting a divide among Fed officials regarding a more aggressive approach have reignited speculation about a half-point reduction. Even Bill Dudley, former New York Fed President and a Bloomberg Opinion columnist, supported a 50-basis-point cut, adding fuel to market expectations.
Despite the growing optimism for a larger cut, only a handful of institutions, like JPMorgan Chase & Co., forecast a half-point reduction. Some analysts believe that the market has overestimated the extent of rate reductions, both for this meeting and the coming year.
“It’s going to be a close call,” noted John Brady, managing director at RJ O’Brien. “The key question is whether the Fed Chair has the full backing of the committee for 50 basis points of easing.” Daniel Ivascyn of Pacific Investment Management Co. suggests that pricing in over 110 basis points of easing this year may indicate that markets are getting ahead of themselves. Ivascyn is pulling back on exposure to shorter-dated notes in favor of five-year maturities.
Some voices, like former St. Louis Fed President James Bullard, remain skeptical of a larger cut, calling the notion “overblown” and arguing that the economy still looks robust. Meanwhile, major asset managers like Vanguard are buying U.S. dollars on the belief that market bets on Fed rate cuts are excessive.
Beyond the immediate rate decision, traders will also be looking at how Fed officials outline the potential scope of future rate cuts in their updated “dot plot,” as well as the tone of Fed Chair Jerome Powell’s press conference.
Historically, Treasury yields have tended to rally following Fed announcements. Over the past two years, yields on the 10-year benchmark have declined on 17 out of 20 Fed decision days, with an average drop of 7 basis points. In contrast, the S&P 500 Index has shown more mixed results, rising only half the time in response to such decisions.
Currently, the policy-sensitive two-year yield has dropped significantly from nearly 5% in April to around 3.5% this week, a level last seen in September 2022. The rally in bonds has gained momentum amid signs of easing inflation and a softening labor market, with longer-term Treasury yields now mostly below 4%.
Looking beyond this week’s decision and the upcoming U.S. elections in November, a weaker economy could ultimately justify the ongoing rally in rates. “The Fed is data-driven, and we believe a soft landing is likely,” said Sinead Colton Grant, Chief Investment Officer at BNY Wealth. “The 10-year yield could decline to as low as 3% or 3.25% if we see a few weak labor reports and further moderation in inflation.”
