Key Highlights

• Fedspeak and a lack of data have conspired to lower December rate cut odds to around 50-50
• We think that once data start to flow, odds will increase, but perhaps not in time for December 
• The basis trade is vulnerable to repo volatility, another reason to commence reserve management operations soon

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December rate cut odds plummet

EXHIBIT #1: LOWER MARKET EXPECTATIONS OF A CUT

_{Source: BNY Markets, Bloomberg}

As of this writing, the market currently sees a less than 50-50 chance that the Federal Reserve will cut the federal funds rate on December 10 at its final policy meeting of the year. This decline is significant. Just a month ago, the market was pricing over 100% odds – indicating a nontrivial chance of a 50bp cut.

Exhibit #1 shows the evolution of the market’s thinking about the December Federal Open Market Committee (FOMC) meeting and the related action in the 10y yield throughout the year. Note that the 10y note moves somewhat in line with the market’s rate expectation.

What has changed the market’s perception from better than a sure thing to a coin flip in just one month? It started at the October FOMC press conference when Chair Powell said that a December move was “far from a forgone conclusion” and picked up steam with subsequent Fed speakers echoing this sentiment, and others declaring outright they would not support a December cut. The lack of data, preventing market participants from getting a read on the jobs and inflation tradeoff, has left Fedspeak as the most heeded factor in assessing the chances of a move next month.

With the government open and data about to flow, will things change again? We know that we will receive the September NFP report on Thursday this week (November 20), and we already have September CPI. The main government data agencies haven’t yet provided a post-shutdown data schedule, so we may not actually see too much before December 10. October data will likely never be published, considering that no collection efforts took place during the shutdown.

As it stands, based on Fedspeak so far, of the 12 voting members of the Committee, we see five that we think would support a cut, four that will not, one who will likely advocate for two cuts, and two more undecided. We note that in the September Summary of Economic Projections, ten FOMC participants (out of a total of 19) saw end-2025 federal funds below 3.75% and one of them expected a funds rate below 3%. So, at least as of two months ago, a not insignificant portion of the FOMC saw three cuts by the end of the year, indicating one more in December after the cuts in September and October.

We think that if there are enough key economic reports available before December 10, they would show a meaningful deterioration in the labor market, sufficient to tip the balance in favor of a cut in December. However, that still all depends on the timing of the data releases. In the absence of official data, the Beige Book, due on November 26, could go a long way towards solidifying views on the Committee. We still see a cut as likely but admit that this is a less highly convicted view than we held just a few weeks ago.

Repo volatility could create financial instability.

The New York Fed’s System Open Market Account (SOMA) manager, Roberto Perli, in a recent speech, added to the growing chorus suggesting that before too long, the Fed will need to start increasing the size of its balance sheet to contain money market rates once reserves have transitioned from abundant (with no effect of changes in reserves on the price of liquidity) to merely ample (with reserves low enough to lead to upward pressure on funding rates). This view is fast becoming the Fed’s default, given the number of speakers who have suggested that open market operations and reserve management policies will eventually be needed to smooth funding markets.

With funding rates moving higher with greater frequency, we are starting to see more frequent use of the Standing Repo Facility (SRF). However, Perli correctly points out that some funding rates have, at times, moved above the minimum bid rate at the facility, meaning that economically, the SRF should be used in large size and frequency. However, there is still some reluctance by counterparties, which undermines the intent of the facility, which is to provide a backstop to repo strains and offer a source of funding at a more attractive rate than that found in the market. As Perli puts it: “It is desirable and fully expected that the SRF be used whenever it is economically sensible to do so. Our counterparties participated in large scale in the repo operations that the Federal Reserve offered in the past; if it makes economic sense, there is no reason why sizable participation cannot take place …”

EXHIBIT #2: BASIS TRADE INCREASES HEDGE FUNDS’ USE OF LEVERAGE

_{Source: BNY Markets, Office of Financial Research, CFTC, Bloomberg}

Perli also indicated that capping excess volatility in funding markets is important not only for controlling the federal funds rate but also for financial stability. As he says (emphasis ours): “Some repo rate volatility is not problematic and is arguably beneficial for allowing markets to send signals on market conditions. However, if repo funding costs become too volatile and unpredictable, the likelihood of forced liquidations of repo-financed Treasury positions increases, and that would create instability in the Treasury cash market and related market segments.”

He is probably referring to the basis trade in the above remarks. Leveraged money has financed – through repo – short positions in Treasury futures against long cash positions, as a means of arbitraging small price dislocations between the two instruments. Should repo become excessively volatile and borrowing rates excessively high, the basis trade could be at risk of unwinding, creating, again in Perli’s words, “instability in the Treasury cash market.” Exhibit #2 shows the growth of hedge-fund-sponsored repo volume as well as the growth of levered money’s short positions in USTs.

We currently see no evidence of this “instability,” but we agree that increased use of the SRF would go a long way in mitigating repo volatility and elevated funding rates. To this end, Kansas City Fed President Jeffrey Schmid recently advocated lowering the rate the Fed pays on reserve balances held at the central bank, making SRF more economically attractive. In any case, the Fed wants the SRF to be used more and is using both moral suasion (central bank jargon for qualitatively encouraging the SRF’s use) and potential tweaks to the rates ecosystem to create economic incentives to use it. 

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