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Why Is Wall Street So Sold on the 50-Basis-Point Rate Cut?

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07/19/2019 | 02:12pm EDT

By Akane Otani

One of Wall Street's most eventful debates centers on a subject that many investors, analysts and Federal Reserve officials appear to consider closed: whether the central bank will cut rates at its two-day meeting ending July 31 by a quarter of a percentage point, as widely expected, or a half a point.

The debate sprang into view this week after John Williams, president of the Federal Reserve Bank of New York, said central banks should "move more quickly to add monetary stimulus" than they otherwise might. The comments, which the Fed later said weren't intended to apply to the current debate, fueled a rally in U.S. stock indexes and a spike in derivatives that measure traders' expectations for Fed rate moves. President Trump said Friday he agreed with the remarks.

The market on Thursday was pricing in as high as a 71% chance of the Fed lowering its federal funds rate by 0.5 percentage point after its July 30-31 meeting, according to CME Group. That was the highest odds this year. The bet is raising the eyebrows of many investors, given the broad consensus that the U.S. economy is generally healthy and officials' typical preference for moving deliberately in cutting rates.

On Friday, the price of eurodollar three-month continuous contracts, retreated to $97.930 after briefly climbing to $97.980 following Mr. Williams' remarks. The contract's price typically rises when rates fall.

And there were few signs that traders were suddenly jumping into the rate markets. As of Thursday, open interest for eurodollar futures -- or the number of futures and options contracts outstanding -- stood at around 13 million contracts, according to CME Group. That was up just slightly from 12.9 million contracts at the end of last week, according to CME Group.

The data suggest that traders, investors and analysts remain unconvinced that, absent a perceived emergency, the Fed would lower rates that quickly.

"When you look at the data, going more than 25 [basis points, or hundredths of a percentage point] is a head-scratcher," said Kevin Giddis, head of fixed income capital markets at Raymond James, in an email. Among economic indicators, "there just aren't that many of them that appear to be getting weak enough to warrant this move."

UBS and Morgan Stanley are among the few investment banks that expect the Fed to lower rates by 0.5 percentage point at the end of the month. Analysts at Goldman Sachs, JPMorgan, Citigroup, Bank of America, Deutsche Bank and Barclays, among others, expect the Fed to make a 0.25 percentage point cut in July.

Those who believe the Fed will make a deeper rate cut say that, with interest rates already at low levels, the central bank has less room to move rates slowly to stave off an economic downturn. That is why Mr. Williams said Thursday that "it pays to act quickly to lower rates at the first sign of economic distress."

Those who are skeptical point to a statement from the Federal Reserve Bank of New York late Thursday that appeared to walk back Mr. Williams' comments. The official was making an "academic speech," not commenting specifically on potential policy moves at the upcoming Fed meeting, a spokesman said. Mr. Trump said he liked the first comments better.

Skeptics also argue that while the U.S. economy is slowing, it is not weakening fast enough to warrant a 0.5-percentage-point rate cut, one that might risk echoing some of the Fed's emergency actions during the 2007-2008 financial crisis.

After a string of better-than-expected economic reports, the Federal Reserve Bank of Atlanta's GDPNow model estimates gross domestic product will increase 1.6% in the second quarter, compared to estimates of as low as 0.9% in May.

If anything, the Fed is likely to make a 0.25 percentage point cut -- but no bigger -- to effectively "reverse" its December rate increase, said Art Hogan, chief market strategist at National Securities. The scale and timing of future rate cuts will depend heavily on economic data in the months to come, Mr. Hogan added.

Others say that even if Federal Reserve Chairman Jerome Powell was leaning toward cutting rates by 0.5 percentage point, it could be difficult to persuade his colleagues.

Comments by other policy makers, including St. Louis Fed President James Bullard and Kansas City Fed President Esther George, suggest they don't see the need for that kind of aggressive action.

"If Powell and team are going to go for 50, there's going to be a lot of dissents," said Andrew Brenner, head of global fixed income at NatAlliance Securities. "They're probably willing to accept one, but not three."

--Daniel Kruger contributed to this article

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