Analysis-Traders brace for least predictable Fed meeting in years

By Saqib Iqbal Ahmed and Carolina Mandl

NEW YORK (Reuters) - Traders in global financial markets are facing extraordinary uncertainty as they await the U.S. Federal Reserve's expected rate cut on Wednesday, setting up markets for a burst of volatility.

Major brokerages expect the Fed to lower interest rates by 25 basis points at the end of its two-day monetary policy meeting, even as financial markets price in a good chance of policymakers starting the easing cycle with a 50-bps reduction.

Fed funds futures, which reflect the market's expectations for the future of monetary policy, have rallied to push the chance of a 50-basis-point rate cut to 61%, against 30% a week ago. The odds narrowed sharply after media reports revived the prospect of a more aggressive easing.

These last-minute moves have left Fed funds futures projecting a record lack of clarity about a Federal Open Market Committee decision, according to a BofA Global Research report.

"It's very rare that you have the market divided on a Fed action 24 hours before the event," George Bory, chief investment strategist for fixed income at Allspring, said.

"Usually, at this point in time, the Fed has communicated, or has led the market to expect, a very specific action," Bory said, adding that given the decision is highly uncertain, positioning is unlikely to be deep.

While Fed decisions often move markets, the relatively even divide between traders expecting 25 bps versus 50 bps makes it likely that no matter what the Fed delivers it is going to take many traders by surprise.

The Fed move is likely to be the largest surprise, relative to market pricing two days ahead of a decision, in over 15 years, according to a Deutsche Bank analysis.

"No one's quite sure ... people have landed on different estimates, guesstimates if you will, and right about half of those people are going to be wrong," said Matt Weller, head of market research at StoneX.

"So they're going to have to adjust their positions ... One way or another, we could see pretty big moves in the market," Weller said.

RIPPLE EFFECT

Asset classes from stocks, currencies and fixed income could all log swings in the immediate aftermath of the decision, investors said.

Stock options are pricing an about 1.1% swing, in either direction, for the S&P 500 on Wednesday, according to options analytics service ORATS.

The recent rally in U.S. stocks - the S&P 500 has advanced for seven straight sessions, rising 4.2% - leaves stocks ill placed to deal with disappointment in the case of a smaller cut. The S&P 500 rose 0.03% on Tuesday, to finish just shy of the record closing high from July.

"With U.S. equities near all-time highs and likely already reflecting a deep Fed easing cycle, the risk-reward skew for much further upside looks poor," said Tara Hariharan, managing director at global macro hedge fund NWI Management.

Traders, who currently expect about 120 bps worth of cuts by year-end may also have to recalibrate their thinking if the Fed decision and Fed Chair Jerome Powell's accompanying commentary shakes their confidence in aggressive rate cuts.

"The market will have to unwind some of this pricing given the U.S. economy continues to be resilient," she said, adding that she expects the front end of the yield curve to steepen.

The Fed decision has the potential to roil foreign exchange markets as well with the dollar/yen pair seen as one of the most sensitive to the rate decision. The dollar rose nearly 1% against the yen to 141.95 on Tuesday.

While a 25 bps rate cut would likely lead to a knee-jerk reaction higher for the U.S. dollar, potentially taking USD/JPY back above the key 142.00 level, a 50-bps rate cut could take the pair back toward the psychologically significant 140 level, StoneX's Weller said.

Glen Capelo, managing director of fixed income at Mischler Financial Group, expects heightened interest rate volatility following the Fed's decision due to the market overextending itself.

Capelo said a 25-basis-point rate cut will most likely lead to a sell-off in Treasuries, although much will also depend on the Fed's press conference.

Michael Rosen, managing partner and chief investment officer of Angeles Investments, sees the bond market's read on the pace of monetary policy as too aggressive.

"The market is pricing in 250 bps of cuts over the next year, a magnitude that only makes sense in the face of a recession. While a recession in the next 12 months is possible, it is not likely, and short-term yields will fall less than the market expects, while long-term rates may even rise from here," Rosen said.

(Reporting by Saqib Iqbal Ahmed, Laura Matthews, Carolina Mandl and Davide Barbuscia; Editing by Megan Davies and Lisa Shumaker)