Investors raise bets on Fed rate cut by half percentage point

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Investors sharply increased their bets on a half-percentage-point interest rate cut by the Federal Reserve next week, as the U.S. central bank prepares to lower borrowing costs for the first time in more than four years.

Swap traders are currently pricing in a 47% chance that the Fed will choose to cut interest rates aggressively in an effort to prevent higher rates from hurting the economy.

On Thursday, they had only considered a 15 percent chance.

A half-point rate cut is now “very likely” after being “almost fully priced in” at some point on Thursday, said Mark Dowding, chief investment officer at RBC BlueBay Asset Management.

Markets still see a 53% chance of a smaller quarter-point cut, but the odds of such a move have fallen significantly compared to Thursday.

On Thursday evening, the Financial Times and the Wall Street Journal reported that the Federal Reserve faces a difficult decision about whether to cut interest rates by half a percentage point or a quarter of a percentage point.

Former New York Federal Reserve President Bill Dudley said Friday he sees a “strong case” for a half-percentage-point interest rate cut next week, stressing the constraining effect on growth of the current rate of 5.25% to 5.5%, a 23-year high.

The Fed typically moves in quarter-point increments, but a 0.5-percentage-point cut could be a preemptive measure if officials feel the economy is at risk of slowing too quickly.

Minutes of the meeting showed that some officials saw it as “plausible” for the Fed to cut interest rates at its last meeting in July, suggesting that a bigger move could help the central bank catch up given that inflation has fallen further since then.

“The path of least regret for the Fed is to start with a 50 basis point cut.” [basis points]“This is the only logical policy option,” said Tim Dowie, chief U.S. economist at SGH Macro Advisors.

Wednesday's Federal Reserve meeting, the last before the November presidential election between Kamala Harris and Donald Trump, was highly charged as officials try to steer the world's largest economy toward a “soft landing,” in which inflation is tamed without triggering a recession.

The yield on the 2-year U.S. Treasury note, which tracks interest rate expectations and moves inversely with prices, fell 0.06 percentage point to 3.59 percent on Friday.

Analysts said the meeting was one of the most uncertain in years, after recent data presented a mixed picture of the economy with some lingering price pressures and a weak labor market.

Figures this week showed headline inflation fell to 2.5% – close to the Fed's 2% target – but core inflation rose more than expected by 0.3% on a monthly basis, partly due to pressures in the housing market.

“If housing and shelter inflation persists, a 50 basis point cut could actually accelerate or amplify that,” said Willie Tollett, chief investment officer at Franklin Templeton Investments, who expects a quarter-point rate cut.

He added that the elections could also complicate the issue of a large cut.

Trump suggested that a Fed rate cut would help Harris as the current vice president, “even though that's something they know they shouldn't do.”

“The Fed’s path is that it wants to do what’s right for the economy, but I don’t think it wants to be seen as benefiting the incumbent by cutting more aggressively,” Tollett added.

But with unemployment high and demand slowing, Fed officials want to prevent the labor market from weakening further.

Federal Reserve Chairman Jerome Powell said last month that the central bank “will do everything we can to support a strong labor market while making further progress toward price stability.”

“It’s a cat-and-mouse game,” said Salman Ahmed, head of global macro at Fidelity International. “We have started the downturn, but a lot of things still need to be worked out.”

He added that during most of the post-pandemic cycle, it became “pretty clear that neither the market nor the Fed had any idea what the Fed was going to do.”

Last December, the Fed forecast a 75 basis point rate cut through 2024 — but by June, it was forecast to make only one quarter-point cut this year.