According to the Chicago Mercantile Exchange's "FedWatch" tool, the futures market has priced in a 63% probability of a significant 50 basis point rate cut by the Federal Reserve on Wednesday, far exceeding the 30% probability a week ago, with only a 37% chance of a "conventional" 25 basis point rate cut.

In other words, after much anticipation and speculation in mainstream financial media articles last Thursday, such as the "FedWire" agency, the market's expectation for the size of the Federal Reserve's first rate cut suddenly shifted from 25 basis points to "more likely a significant rate cut", but it is still uncertain.

There is an opinion that the Federal Reserve is "afraid" to cut rates significantly by 50 basis points, as the current economic data in the United States has not reached a crisis level that warrants a significant rate cut. Instead, a significant rate cut may validate fears behind the scenes of the Federal Reserve and trigger a stock market sell-off.

However, at the same time, several media outlets considered as "Fed barometers" have written articles to promote the potential for a significant rate cut, which is another wave of sentiment that cannot be easily ignored. In other words, more and more market participants are starting to believe that the larger the rate cut, the better.

As summarized by analysts from Swiss private bank Edmond de Rothschild, "Given the speculation in the market about the Fed's intentions, there is rarely so much uncertainty."

Goldman Sachs derivatives trader Brian Garrett analyzed the data of "futures market pricing" and "actual actions by the Federal Reserve" over the past fifteen years. He found that during rate hike cycles, the actions of the Federal Reserve since the Bernanke era generally align with market pricing. However, during rate cut cycles, there is a certain degree of uncertainty. For example, during the 2008 financial crisis and the 2020 COVID-19 pandemic, the Federal Reserve unexpectedly turned more dovish, but the rate cuts in certain situations, such as in September 2019, were lower than market pricing.

Deutsche Bank pointed out in a research report that since last week, the media has hyped expectations of a 50 basis point rate cut by the Federal Reserve, which is actually weaker than the 75 basis point rate hike on the eve of June 2022. However, the current market-priced rate cut is close to 40 basis points, increasing the probability of a surprise rate cut by the Federal Reserve to the highest level in fifteen years two days later. If the media does not counterbalance market expectations in the next two days, it is very likely that there will be a substantial 50 basis point rate cut on Wednesday. 'Media discourse in the next 12 hours is crucial for consolidating pricing.'

In fact, Tony Pasquariello, Head of Hedge Fund Sales at Goldman Sachs, believes that the Federal Reserve has no reason to choose a 50 basis point rate cut instead of a 25 basis point rate cut. First, because Federal Reserve officials before the blackout period did not endorse 'using a significant rate cut to initiate a rate-cutting cycle', and CPI data does not support a substantial rate cut. 'A 50 basis point rate cut is usually used in a high-pressure environment,' unless the Federal Reserve wants to 'buy a little insurance' for worse employment data during the 'long wait period' between September and November FOMC meetings.

Charlie McElligott, Cross-Asset Strategist at Nomura Securities, pointed out that a heavyweight media article on Sunday stated that since interest rates have not reached neutral levels and the labor market is cooling, it is best to use a substantial rate cut to initiate a new cycle. This seems to coincide with remarks by Federal Reserve Chairman Powell at the August Jackson Hole Symposium, that the Federal Reserve is not seeking or welcoming further cooling of the labor market.

Furthermore, at the time Powell also stated that 'the upward risks to inflation have diminished', which guided the market's focus on cooling labor market conditions, which is why the market-priced rate cut for this year is as high as 121 basis points, with both September and November expected to see a 50 basis point rate cut. This is also why the two-year US Treasury yield returned to a two-year low last week and the yield curve showed a steepening 'bull market trend' after the rate cut.

The outspoken financial blog Zerohedge summarized that since Federal Reserve officials entered the blackout period, within a short period of time, while employment and manufacturing data continued to be weak, several core inflation indicators such as CPI and PPI exceeded expectations. This is also why the market's expectation of a substantial rate cut in September did not completely turn into a 'done deal'.

But this brings us an interesting paradox: whether intentional or not, the Federal Reserve seems to be 'testing the waters' with a substantial 50 basis point rate cut through the media, which means that any rate cut below this level would trigger market selling. The expectation of a substantial rate cut was not recognized by the market two weeks ago; on the contrary, a 50 basis point rate cut was seen as a sign of panic by the Federal Reserve.

Zerohedge also mentioned that if the Federal Reserve 'disappoints and only cuts rates by 25 basis points', then risk assets may face a severe (although temporary) downward shock, triggering stop-losses in the CTA long trend in G10 sovereign bond markets accumulated to a three-year high, causing a huge 'financial tightening shock'.

The next focus is how the 'dot plot' of the Fed's rate trend in 2025 bridges the huge gap with market pricing.

The market performance during the easing cycle depends on the ultimate destination: whether there will be an economic recession. If a recession is avoided, the large cap of US stocks will rise 14% in the 12 months after the first rate cut. If the US falls into a recession within 12 months, the median return on US stocks in the first year after the first rate cut will be -15%.

Earlier, BlackRock issued a warning regarding the bond market, downgrading its rating on US short-term treasuries from 'overweight' to 'underweight', and warned that the market's expectations for Fed rate cuts were too aggressive and unlikely to 'come true'. The strategists, led by Chief Investment Strategist Wei Li, believe that the speculation that the Fed has waited too long on the easing issue and will now accelerate rate cuts to support the US economy is incorrect.

Editor/Lambor