(Bloomberg) -- Bond investors that have been frantically wagering on the size of the Federal Reserve's first interest-rate cut in four years are about to find out whether they made the right trade.
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The market is fully pricing in a quarter-point rate reduction on Wednesday, when the US central bank is expected to kick off its rate-cutting cycle, with the chance of a bigger move viewed as a coin-flip. Treasuries have rallied into the decision, climbing for a fifth-straight month and driving short-dated yields -- those most sensitive to Fed policy -- to their lowest in two years.
All that enthusiasm for cuts is creating a risk of sharp losses for traders if officials opt for a more modest 25-basis-point reduction after all. Despite facing the most uncertain scheduled Fed meeting since 2007, futures traders have a record number of wagers riding on an outsized cut.
"The Fed is going to have to strike some balance here," said George Catrambone, head of fixed income at DWS Americas. "This is a market that is unbalanced with respect to the amount of rate cuts that they're pricing in."
After coalescing around a smaller quarter-point cut in early September, traders boosted their bets for a half-point reduction after a report that Fed officials are split over taking a more aggressive policy path.
Bill Dudley, former president of the Federal Reserve Bank of New York and Bloomberg Opinion columnist, further added to the repricing, declaring that the Fed should cut 50 basis points, and that he expected it would.
What Bloomberg Strategists Say...
"For bonds, having rallied hard, most of the risks are to the downside in the event that the Fed opts for 25 bps. What's more, if the Fed does cut 25 bps, it's also likely to signal 25-bp cuts at subsequent meetings, too. That means market a repricing of the current expectations for 116 bps of cuts through December now reflected in the futures market."
-- Edward Harrison, MLIV macro strategist
Still, JPMorgan Chase & Co. is one of the few Wall Street banks forecasting a large cut, and some commentators argue that the market has gone too far in pricing in rate reductions, both this week and heading into next year.
"It is going to be a close call," said John Brady, managing director at RJ O'Brien. "The key question is whether the Fed Chair has the full support of his committee for 50 bps of easing."
Beyond the cut itself, trading will be influenced by how central-bank officials outline the scope of total rate cuts over the next two years via their updated dot plot, as well as the tone of the press conference from Chair Jerome Powell.
During the past two years, Treasuries have shown a tendency to rally after a Fed decision. For example, yields on the 10-year benchmark security have fallen on 17 of the past 20 decision days, dropping by an average of 7 basis points. Stocks have performed less consistently, with the S&P 500 Index rising half the time over the same period.
The policy-sensitive two-year yield has tumbled from near 5% in late April and traded near 3.5% this week, a low from September 2022, as the clamor for rate cuts gained momentum against the backdrop of easing price pressures and signs of a softening labor market. Longer-dated Treasury yields are mostly trading below 4%.
Beyond the Fed's messaging this week, and also the US election in November, a weaker economy would ultimately vindicate the current rally in rates.
"The Fed is data dependent and our view is that a soft landing is likely," said Sinead Colton Grant, chief investment officer at BNY Wealth. "The 10-year yield could go as low as 3%, 3.25% from a couple of weak labor reports and further moderation of inflation."
--With assistance from Edward Bolingbroke and Ye Xie.