Analysis-Traders brace for least predictable Fed meeting in years, by Reuters

By Saqib Iqbal Ahmed and Carolina Mandl

NEW YORK (Reuters) – Traders in global financial markets are facing tremendous uncertainty as they await the U.S. Federal Reserve’s expected interest rate cut on Wednesday, setting markets up for a burst of volatility.

Major brokers expect the Fed to cut interest rates by 25 basis points at the end of its two-day monetary policy meeting, even as financial markets see a strong chance that policymakers will start the easing cycle with a 50 basis point cut basic.

Fed funds futures, which reflect market expectations about the future of monetary policy, rose to push the chance of a 50-basis-point rate cut to 61 percent, up from 30 percent a week ago. The odds narrowed sharply after media reports revived the prospect of more aggressive easing.

Those last-minute moves left Fed funds futures showing a record lack of clarity on a Federal Open Market Committee decision, according to a BofA Global Research report.

“It’s very rare that the market gets split on a Fed action 24 hours before the event,” said George Bory, chief fixed income investment strategist at Allspring.

“Usually at this point, the Fed has communicated or led the market to expect a very specific action,” Bory said, adding that with the decision highly uncertain, the positioning is unlikely to be deep.

While Fed decisions often move markets, the relatively even spread between traders expecting 25 bps versus 50 bps makes it likely that whatever the Fed delivers will take many traders by surprise.

The Fed’s move is likely to be the biggest surprise to market prices two days before a decision in more than 15 years, according to a Deutsche Bank analysis.

“No one is quite sure … people have gotten different estimates, estimates if you will, and rightly about half of those people are going to be wrong,” said Matt Weller, head of market research at StoneX.

“So they’re going to have to adjust their positions … One way or another, we could see some pretty big moves in the market,” Weller said.

WAVE EFFECT

Asset classes in equities, currencies and fixed income could see swings immediately after the decision, investors said.

Options on the stock are pricing in a swing of about 1.1%, either way, for Wednesday, according to options analysis service ORATS.

The recent rally in U.S. stocks — the S&P 500 has advanced for seven straight sessions, up 4.2 percent — doesn’t leave stocks reeling from the disappointment of a smaller cut. The S&P 500 rose 0.03% on Tuesday to finish just off July’s record closing high.

“With US stocks near all-time highs and likely already reflecting a deep Fed easing cycle, the risk-reward trade-off for much further out looks poor,” said Tara Hariharan, managing director at global hedge fund NWI Management.

Traders, who currently expect cuts of about 120 bps by the end of the year, may also have to recalibrate their thinking if the Fed’s decision and accompanying comments from Fed Chairman Jerome Powell shake their confidence in aggressive tapering of installments.

“The market will have to reduce some of these prices given that the US economy continues to be resilient,” she said, adding that she expects the front end of the yield curve to flatten.

The Fed’s decision has the potential to disrupt currency markets as well, with the dollar/yen pair considered one of the most sensitive to the rate decision. The dollar rose nearly 1 percent against the yen to 141.95 on Tuesday.

While a rate cut of 25 bps would likely lead to a sharper reaction for the US dollar, potentially moving back above the key level of 142.00, a rate cut of 50 bps could take the pair back to the psychologically significant level of 140, StoneX’s Weller. said.

Glen Capelo, managing director of fixed income at Mischler Financial Group, expects increased interest rate volatility following the Fed’s decision due to market overextension.

Capelo said a 25 basis point rate cut would most likely lead to a sell-off in Treasuries, although much would also depend on the Fed’s press conference.

Michael Rosen, managing partner and chief investment officer of Angeles Investments, believes the bond market’s interpretation of the pace of monetary policy is too aggressive.

“The market is pricing in 250 bps of cuts over the next year, a magnitude that only makes sense in the face of a recession. While a recession in the next 12 months is possible, it is not likely, and short-term yields will fall less than the market expects, while long-term rates could even rise from here,” Rosen said.