The market is currently assigning an 8% chance for a 50 basis point interest rate cut. However, recent economic reports support the idea of a rate cut. The US Consumer Price Index (CPI) met expectations, while the Core Personal Consumption Expenditures (PCE) is predicted to rise by 0.20%, lower than the 0.35% increase in the CPI. Additionally, Core goods prices in the PCE are expected to drop, which differs from the CPI results. The Federal Reserve is concerned about inflation but pays more attention to the labor market. Recent jobless claims in the US climbed to their highest level since 2021, though this may be a temporary issue linked to a spike in Texas. Two weak Non-Farm Payroll (NFP) reports and the Fed’s previous reactions to similar situations suggest a 50 basis point cut might act as “insurance” if labor market conditions worsen.

Anticipation for Insights from the Wall Street Journal

There is eager anticipation for articles from Wall Street Journal writers who have influenced market expectations ahead of Fed decisions in the past. A 50 basis point cut could be preferred to address potential risks in the labor market and manage uncertainty. If this cut occurs, it will likely be termed an “insurance cut,” with future interest rate decisions remaining data-driven. Conversely, if only a 25 basis point cut is implemented, a strong dovish statement may follow to reassure the market. The market is almost fully expecting a 25 basis point cut, but we believe there is a higher chance of a surprise 50 basis point “insurance cut” from the Fed next week. Although the recent CPI report met forecasts, the Fed’s preferred inflation measure, the PCE, might show core goods prices actually falling. This gives the Fed the chance to focus on its primary concern: the labor market. The main factor for a larger cut is the noticeable softening in employment data. Last week’s initial jobless claims rose to 264,000, the highest level since late 2021, following two disappointing NFP reports of 145,000 and 130,000. Even if this data is a one-time issue, the Fed cannot afford to wait and see if a sharper downturn is beginning.

Historical Context and Market Strategy

We experienced a similar situation last September when the Fed made a surprising 50 basis point “insurance cut” after a weak NFP report. Based on this precedent, options that benefit from larger-than-expected interest rate drops seem undervalued now. Traders should consider positions in short-term interest rate futures, like SOFR options, that would gain from a dovish surprise that prompts the market to reevaluate the path of interest rates. Before the meeting, watch for an article from Nick Timiraos at the Wall Street Journal. If he hints that a 50 basis point cut is being discussed, market probabilities will shift dramatically, and any cheap options will vanish. Any indication of a debate about a larger cut should prompt quick positioning for a 50 basis point move. This strategy aims to manage risk, both for traders and for the Fed. A bigger cut now allows the Fed to pause and observe how the economy reacts, which they might view as safer than cutting too slowly and needing to respond to a deteriorating labor market later. If they opt for a 50 basis point cut, they will highlight its “insurance” purpose, indicating that future policies will depend heavily on incoming data. Even if the Fed only implements a 25 basis point cut, the risks may be limited. In that case, we expect a very dovish statement with promises of aggressive action if the labor market continues to weaken. This could pave the way for a potential 50 basis point cut in the October meeting, maintaining downward pressure on short-term rates. Create your live VT Markets account and start trading now.

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