Bond traders bet big on bold fed rate cuts

Bond traders are increasingly betting that the Federal Reserve will cut interest rates by half a percentage point in September, breaking with the traditional quarter-point increment.

A shift in sentiment is evident in the federal fund's futures market, where softer-than-forecasted inflation data released Thursday unleashed a frenzy of buying of October contracts that spilt over into Friday.

Expiring Oct. 31, the contracts already fully price in a quarter-point rate cut at the Fed's September 18 meeting.

Any additional buying at higher price levels then indicates growing expectations that the Fed could start its first easing cycle in years with a more substantial move.

“The Fed is very well-placed to potentially cut in September,” said Marilyn Watson, head of global fundamental fixed-income strategy at BlackRock Inc., on Bloomberg TV. While she expects a quarter-point cut, “we think they’ll probably tee things up potentially in July. We know that the Fed has been very, very data dependent.”

The positions would also benefit if expectations for quarter-point rate cuts on both July 31 and September 18 rise. However, traders gave up hope for a July rate cut weeks ago, and no major Wall Street bank is currently predicting one.

According to data from CME Group Inc., Thursday's buying established new risk, with volume just shy of 260,000 contracts, the most ever for the October tenor. Buying interest remained lofty on Friday, with volume well over 150,000 by 1:30 p.m. New York time.

Market-implied expectations for Fed policy didn't change much Friday following a report on producer prices that did little to move the needle compared with Thursday's consumer price report. 

The recent action in the bond market is just one part of a shift in trader bets for more aggressive Fed action on the economy. With inflation data continuing to swing market sentiment, attention will remain on the Fed's meetings ahead and possible rate cuts.