Rates Traders Are Camped on Either Side of Big Divide Over Fed Cuts

(Bloomberg) -- The relative steadiness of market pricing for 2019 Federal Reserve rate cuts over the past month may look like conviction, but it’s hiding a major divergence in investors’ views and potentially a window of opportunity.

Fed funds futures indicate about 80 basis points of easing by the end of the year. While that’s up a bit from where things stood at the beginning of June, it doesn’t necessarily indicate traders see three standard quarter-point cuts as a lock. The odds of more aggressive action this year have been swinging around a lot over recent weeks, and the latest moves are in favor.

What happens beyond this month’s Fed meeting -- which almost every market observer agrees will deliver a cut -- is hotly debated. Investors are falling into two camps, with big implications for their portfolios, according to Frances Donald at Manulife Asset Management. Those optimistic about the economy’s prospects are positioning for a couple of so-called insurance cuts, while some pessimists say rates are headed toward zero.

“As of July 1 we’re in the longest economic cycle in modern history, which means you have to pick a camp,” said Donald, head of macroeconomic strategy. “Either we’re headed towards a near-term recession or we’re in a super-cycle.”

A mixed bag of U.S. corporate earnings has pushed stocks lower over the past few days and buoyed Treasuries, driving benchmark 10-year yields back down toward 2%. A burst of activity Thursday shifted the odds in favor of a half-point cut this month rather than the quarter-point considered most likely until now. That’s following remarks by New York Fed President John Williams that it “pays to act quickly to lower rates at the first sign of economic stress.”

The path of rates for the rest of this year also remains a moving target, as over recent weeks the market-implied probability of 50 or 100 basis points of cuts by December has swung sharply. The latest moves have seen bets on aggressive action overtake the more moderate camp.

See here for more analysis by Markets Live blogger Cameron Crise

The latest action in eurodollar futures and options points to wagers both ways. On Wednesday, some traders staked out new short positions in December 2019 eurodollar contracts, suggesting a bet on less easing than is currently priced. Opposing positions are still in play, judging by open interest data and information from traders close to the action.

Investors are grappling with the Fed’s priorities as it turns to pre-emptive action to avert a slump, even as the jobless rate remains close to a 50-year low.

For Donald, this stretch of uncertainty presents an investment opportunity. She expects any significant bond-market repricing will hold off until the Fed’s intentions become clearer, closer to the fourth quarter. In the meantime, the combination of contained yields, a supportive Fed and her expectation for a de-escalation in U.S.-China trade tensions creates “a pocket for risk-on.”

“That’s a lovely environment for risk assets,” she said. “Is it sustainable? Probably not, but I’m certainly willing to participate in what I expect to be another 3-5% rally” in U.S. stocks.

--With assistance from Cameron Crise and Benjamin Purvis.

To contact the reporters on this story: Emily Barrett in New York at ebarrett25@bloomberg.net;Edward Bolingbroke in New York at ebolingbrok1@bloomberg.net

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Mark Tannenbaum, Nick Baker

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