Some traders in the US interest rate options market are currently making a radical bet on the Fed's rate cut path: betting heavily that the Fed will cut rates by up to 300 basis points in the next nine months!
In the past three trading days, data from the options market linked to the secured overnight financing rate (SOFR) shows that if the Federal Reserve lowers its key interest rate to 2.25% before the first quarter of 2025, these increasing bets will benefit.
This means that the Federal Reserve will cut interest rates by at least 300 basis points at current levels, which means it will need to cut rates 12 times compared to the usual 25 basis point rate cut.
Considering that the Federal Reserve will hold a total of six interest rate meetings until March next year, this also indicates that if the Federal Reserve really wants to cut interest rates so much in nine months, it will need to cut interest rates by an average of 50 basis points per meeting. If the initial interest rate cut is carried out at a pace of 25 basis points, at least 75 basis points of interest rate reduction will be required at some meetings.
Undoubtedly, the extreme dovish bets mentioned above are far from the fair estimates of the current interest rate futures market, which can be described as a "one hundred and eight thousand miles" difference.
At present, market participants generally expect that the Federal Reserve will cut interest rates by a total of about 75 basis points over the next nine months. The interest rate chart released by Federal Reserve officials earlier this month showed that the Fed will only cut interest rates by 25 basis points by the end of this year, and a total of 125 basis points by the end of 2025.
As we discussed last Friday, there are two large "extreme bets" emerging in the interest rate futures market, boldly predicting that the Federal Reserve will start cutting interest rates next month. It is not difficult to see that an increasing number of market participants are currently deviating from mainstream market expectations and the Federal Reserve's own predictions, and are beginning to establish some bets to hedge tail risk outcomes, such as the Federal Reserve's rapid and extreme interest rate cuts
However, as many transactions in such contracts are anonymous, it is difficult to determine the institutions or groups behind these bets.
So, why did these traders make such radical loose bets?
The reason is not difficult to find, because if the Federal Reserve is really so dovish in the next six months - a sharp drop of 300 basis points in nine months - then there is only one possible scenario: the US economy suddenly enters a rapid recession!
We clearly cannot predict whether this scene will happen in a few months. But judging from the recent sluggish performance of a series of US economic data and the warning signals issued by many economic recession indicators, it is not difficult to understand why some people are "gambling" like this
According to data released by the American Advisory Council on Tuesday, consumer confidence in the United States has once again weakened this month due to expected weak business conditions, job markets, and income prospects. The US Chamber of Commerce Consumer Confidence Index fell to 100.4 in June, and the data for May was revised down from 102 to 101.3. In terms of sub indices, the expected index has been below 80 for five consecutive months (usually indicating the critical value of an economic recession) and is currently hovering near a 10-year low.
Overall, both "hard data" and "soft data" are currently declining in the macroeconomic data of the United States. Hard data has even reached a 21 month low.
Note: The red line represents hard data, and the green line represents soft data (survey data)
Some economic recession warning signals are once again flashing red light.
As shown in the figure below, the Leading Economic Index (LEI) in the United States has now fallen by 14.7% from the peak of this economic cycle. In the past 65 years, this decline has only occurred during economic downturns. This index comprehensively measures the performance of the US labor market data, manufacturing data, real estate data, and even the stock and bond markets.
In addition, the yield difference between the 2-year/10-year US Treasury bonds also broke through -50 basis points on Tuesday, marking the first time this year. As of the end of the New York session, the 2-year US Treasury yield rose 1.1 basis points to 4.745%, and the 10-year US Treasury yield rose 0.8 basis points to 4.245%.
This is the most concerning part of the yield curve. Normally, the yield curve of US Treasury bonds tends to tilt upwards, with short-term bond yields lower than longer bonds with greater risk. But since mid-2022, the yield curve has been inverted, suggesting that the market expects an economic recession.
Ian Shepherdson, Chief Economist of the Temple of Ten Thousand Macroeconomics Research Company, recently warned that "a slowdown in the US economy is real and continuing to develop.".
In fact, some Federal Reserve officials have also expressed their vigilance against the risk of economic downturn this week. This year, FOMC voting committee member and San Francisco Fed Chairman Daley stated that the US labor market is approaching a turning point, and further slowdown may mean an increase in unemployment. Daley urged decision-makers to remain vigilant and open to various economic scenarios that may arise.