From the perspective of market expectations, tonight will undoubtedly be the most exciting Federal Reserve interest rate night in more than a decade. With the expectation of a 50 basis point rate cut by the Federal Reserve during this meeting quickly heating up in the past few trading days, a large number of market participants have also made bets on the potential major moves by the Federal Reserve. And one serious risk this creates is:

If Fed officials unexpectedly choose to initiate easing with the standard method (a 25-basis point rate cut), fixed income traders who have made record bets may face huge losses.

According to industry data, the number of open interest contracts on October federal funds futures that investors have used to bet on this week's Fed interest rate meeting has surged to the most extreme level since the derivative was launched in 1988.

Most of these new bets are on the Fed cutting rates by 50 basis points this month, with the scale of the increase in related positions this week being particularly significant—new positions in the past two trading days accounted for almost one-third.

In the futures market linked to the secured overnight financing rate (SOFR), a new large transaction similar to betting on a 50 basis point rate cut by the Fed this month also appeared during Monday's trading session.

Currently, as the Fed is almost certain to cut rates this week, the debate among investors is mainly focused on the size of the first rate cut.

Although the mainstream consensus in the market at the beginning of last week was that the Fed would first choose a 25-basis point rate cut, expectations in the market have changed drastically in the past few days—especially with well-known journalist Nick Timiraos, often called the 'new Fed News Agency,' repeatedly stating that 'the size of the first rate cut is still uncertain,' and with senior figures like former New York Fed President William Dudley calling on Fed policymakers to take more aggressive action, the possibility of a 50-basis point rate cut currently seems to be gaining the upper hand.

The Chicago Mercantile Exchange's "Fed Watch Tool" shows that traders in the interest rate futures market currently expect a 64% probability of a 50 basis point rate cut by the Federal Reserve tonight, while the probability of a 25 basis point rate cut has dropped to 36%.

Behind the rapid pace of a 50 basis point rate cut, people have completely ignored the better-than-expected US retail sales data from last night. Data released by the US Department of Commerce on Tuesday showed that US retail sales recorded a monthly rate of 0.1% in August, exceeding the expected -0.2% and revising the previous value from 1% to 1.1%. The data suggests that the US economy remained resilient in the third quarter.

Obviously, in the context of the Federal Reserve's "silent period" (with no statements from any Federal Reserve officials) and economic data that is not completely favorable to a 50 basis point rate cut, market expectations have undergone such a dramatic change in just a few trading days, which is unprecedented.

Is there significant market risk tonight?

Behind this, on the one hand, people may once again marvel at the immense influence of some media outlets as the "voice" of the Federal Reserve, while on the other hand, it undoubtedly indicates that tonight's market situation may face significant risks.

According to data compiled in the industry, apart from the emergency rate cut by the Federal Reserve in March 2020 during the outbreak of the pandemic, this meeting will be the most confusing decision for interest rate swap traders since 2007. Mark Chandler, Chief Market Strategist at Bannockburn Global Forex, pointed out that there have been very few bets of this magnitude before a Federal Reserve meeting.

Strategists at Bespoke Investment Group also said that during Powell's tenure at the Federal Reserve, it is rare for the market to still be so uncertain about what action the Federal Reserve will take with only one day left before the decision date. Although the Federal Reserve may be satisfied with the market being 100% convinced that it will cut rates.

In the bond market, the recent surge in bond prices due to expectations of rate cuts has pushed yields significantly lower. The yield on the US two-year Treasury bond touched a two-year low of 3.52% this week.

Subadra Rajappa, the head of interest rates strategy at the Industrial Bank of France usa, said that this could lead to significant selling pressure in the market in the case of a smaller rate cut by the Federal Reserve and if Powell conveys a gradual signal. Statements such as 'if the Fed cuts by 25 basis points instead of 50, market reactions will be much stronger, positions will be rearranged, optimistic sentiment, and a more accommodative financial environment' may undergo scrutiny.

Kathy Jones, Chief Fixed Income Strategist at Charles Schwab, stated that short-term US Treasury bonds are more sensitive to Federal Reserve policy, and they may face the greatest impact, especially considering the market is 'already priced quite aggressively.' 'If the Fed ultimately only cuts by 25 basis points, as an initial reaction, you could easily see yields rebound by 10 or 15 basis points.'

A survey conducted by 22V Research this week before the Federal Reserve decision showed that investors expecting a 25 basis point rate cut this week had differing expectations on whether this rate cut would lead to a 'risk-on' or 'risk-off' market reaction. At the same time, investors expecting a significant 50 basis point rate cut by the Federal Reserve believe that if the rate cut is smaller, it will trigger a 'risk-off' move in the market.

Steve Sosnick, Chief Strategist at Interactive Brokers, still believes that the Federal Reserve is likely to lean towards a 25 basis point cut, but he points out that years of trading experience have taught him to respect the information released by the market. He stated, '(Recent) market information has been consistently pointing to a 50 basis point rate cut.'

Sosnick pointed out that if the Federal Reserve ultimately chooses a 25 basis point rate cut, the market may generally feel disappointed. The stock market always craves more liquidity, while the bond market has already almost digested the expectation of a significant rate cut in future meetings. Therefore, a smaller rate cut will be detrimental to both.

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