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Investors have sharply increased their bets on a half-percentage-point Federal Reserve interest rate cut next week as the U.S. central bank prepares to cut borrowing costs for the first time in more than four years.
Swaps traders currently estimate a 49 percent chance Fed will go for a sharp reduction in rates in order to prevent damage to the economy due to high rates.
On Thursday, they estimated the probability at just 15 percent.
The revaluation helped lift stocks on Friday, pushing the S&P 500 and Nasdaq Composite to their biggest weekly gains this year, up 4% and 6%, respectively.
Mark Dowding, chief investment officer at RBC BlueBay Asset Management, said a half-point rate cut was now “very relevant” after it was “almost completely priced out” at one point on Thursday.
Markets still price a quarter-point rate cut at 51 percent, but the likelihood of such a move has fallen significantly since Thursday.
The Financial Times and the Wall Street Journal reported Thursday evening that the Fed faces a close call about whether the score should be reduced by half a point or by a quarter of a point.
Former New York Federal Reserve Bank President Bill Dudley said Friday he sees a “strong case” for a half-percentage-point rate cut next week, highlighting the growth-restrictive impact of the current 5.25% to 5.5% rate, a 23-year high.
The Fed typically cuts rates by a quarter percentage point, but a 0.5 percentage point cut could serve as a preemptive measure if officials believe the economy is at risk of slowing too quickly.
Some officials viewed a Fed rate cut as “likely” at its last meeting in July, according to minutes from that meeting, suggesting that a bigger cut could help the central bank catch up as inflation has continued to fall since then.
“The path of least regret for the Fed is to lead with 50% [basis points]”This is the only logical policy choice,” said Tim Dye, chief U.S. economist at SGH Macro Advisors.
Gabriele Foa, manager of the Algebris Investments fund, said the Fed “was in a better position… with the down payment[ing] contraction” rather than risk “falling behind the curve during a downturn.”
The Fed's meeting on Wednesday is the last before Presidential elections in November between Kamala Harris and Donald Trump is growing increasingly tense as officials try to steer the world's largest economy toward a “soft landing” in which inflation is tamed without triggering a recession.
A closely watched University of Michigan survey found that consumers' expectations for inflation next year fell to 2.7 percent, the lowest since late 2020. The university's report on Friday also showed that consumer sentiment rose to a four-month high in September.
The yield on two-year U.S. Treasury notes, which tracks interest rate expectations and moves inversely with prices, fell 0.06 percentage point to 3.59% on Friday.
Analysts said the meeting was one of the most uncertain in years as recent data painted a mixed picture of the economy, with both persistent price pressures and weakness in the labor market.
This week's numbers revealed the headline inflation fell to 2.5 percent — close to the Fed's 2 percent target — but core inflation rose more than expected, 0.3 percent month-on-month, partly due to pressure in the housing market.
“If there is inflation in the housing and housing sector, a 50 basis point cut could actually accelerate or intensify it,” said Wiley Tollett, chief investment officer at Franklin Templeton Investment Solutions, who expects a quarter percentage point cut.
He added that elections could also complicate matters with major cuts.
Trump suggested that lowering the Fed rate would help Harris as the sitting vice president, “even though they know they shouldn't do it.”
Tollett added: “The Fed's path is they want to do what's right for the economy, but I don't think they want to be seen as doing the incumbent a favor by cutting rates more aggressively.”
However, with unemployment rising and demand falling, Fed officials want to prevent the labor market from weakening further.
Last month, Fed Chairman Jay Powell said the central bank would “do everything possible to support a strong labor market as we continue to move toward price stability.”
Salman Ahmed, global head of macro at Fidelity International, said: “It's a cat and mouse game… we have started the cutting cycle but much of it is still to be determined.”
He added that for much of the post-pandemic cycle, it has become “pretty clear that neither the market nor the Fed has any idea what the Fed is going to do.”
Last December, the Fed forecast a 0.75 percentage point rate cut in 2024, but by June it was announced that it would cut rates by only a quarter of a percentage point over the year.
Additional material by Kate Duguid and Laurence Fletcher