Markets are betting on a supersized rate cut. Why the Fed may disappoint.

Simone Del Rosario: Markets are increasingly betting the Federal Reserve will make a supersized rate cut after this week’s meeting. 

There are two camps. Those who believe the Fed will cut interest rates by 25 basis points. And those who believe the Fed will double up to 50. 

A week ago, two out of three futures traders were betting the Fed would do a 25 basis point cut: Modest, measured, standard.

But as the Fed started its 2-day meeting Tuesday morning, it completely switched. Now two out of three futures traders are betting on a jumbo cut to kick off this rate-cut cycle.

Joseph Wang: The market is thinking this because the market is sniffing out some economic weakness. They’re noticing that the unemployment rate has gone up. It seems like there’s a lot of indicators that the Fed might be over-tightening, and so in order to get ahead of this, the Fed might want to do with a supersized cut. Now I’m not in that camp, because so far, what I hear from Fed speakers is that it’s more likely that the economy is normalizing.

Simone Del Rosario: The Fed Guy’s Joseph Wang is in the 25 basis-point-camp, as is former Fed adviser and CEO of QI Research Danielle DiMartino Booth. 

Danielle DiMartino Booth: They want to be measured and gradual. They want to be Greenspan-esque, right? Greenspan had 17 25-basis-point rate hikes in a row. So it was a little bit different dynamic. It was a tightening campaign, but they want to be as measured. They want to be able to say, we’re just going to take we’re going to engineer a soft landing. We’re going to be taking interest rates down at a very slow pace. 

Simone Del Rosario: When inflation was getting out of hand in 2022, the Fed went on this big rate hike campaign to tighten monetary conditions and get people and businesses to spend less, which would hopefully bring down prices. 

They hiked the Fed funds target range all the way to 5.25% to 5.5%, and they’ve held it there for more than a year now. This is the highest the rate has been since early 2001. 

But now inflation is very close to the 2% target, unemployment is rising, and it’s time to bring down this rate before triggering a recession.  

Now how low will the rate go? Markets seem to think by next summer, the rate will go down to below 3%, which would mean cutting 250 basis points in less than a year. 

Joseph Wang: The pricing in the market seems to be pretty aggressive. From my perspective, I think there’s too much doom and gloom being priced in. My base case expectation is that rather than having a series of huge cuts that the market is assuming that we have, some steady 25 basis point cuts, and maybe the cut cycle ends, let’s say around three and a half percent, rather than below 3%.

Simone Del Rosario: Wherever it lands, you will see a change in what it costs to borrow money. In the same way as when the Fed was hiking rates, and mortgage rates, auto loans and credit card interest rates got more expensive, this time those interest rates will also go down. 

In fact, we’re already seeing it. In anticipation of Wednesday’s Fed cut, mortgage rates have fallen to levels not seen since early 2023. Now, if the Fed cuts by 25 basis points, that’s pretty much priced into the mortgage rates we see today. If they go jumbo-sized to 50 basis points, we could see mortgage rates go down even more. 

Subscribe to the Straight Arrow News YouTube page and tune in Wednesday at 2:10 ET, I’ll be reporting live over there with the Fed’s decision and you’ll also hear from Fed Chair Jerome Powell.