Fed Fund Futures Could Be Setting Market Up for a September Sell-Off

You would think that with everything Fed Chairman Ben Bernanke has said publicly thus far regarding the current turmoil in the mortgage and credit markets, the market might be at least somewhat doubting that a Fed Funds rate cut is coming later this month at the next FOMC meeting. After all, Bernanke came out and said the Fed is not responsible for bailing out lenders and consumers who made bad decisions in a loose lending environment. Quotes like that should at least temper people’s expectations a little bit that a rate cut this month is essentially guaranteed. Well, that does not appear to be the case.

As of late Wednesday, a 25 basis point cut was fully priced into the market and there was a whopping 72% chance of a 50 basis point cut also priced into futures quotes. Given the actions we have seen from the Fed thus far (namely choosing to inject liquidity rather than lower interest rates for consumers) and the words they have chosen in public speeches in recent weeks, I have to take “the under” on the Fed Funds futures bet.

Now, that is not to say that there won’t be a rate cut. That could surely happen, and you could justify it several ways. It just seems to me that the Fed wants to try every other option they have at their disposal before giving in with a rate cut, which many see as bailing out people who made ill-advised decisions and thus contributing to a moral hazard issue.

Because of that, I think saying there is a 100% chance of a cut this month is overly optimistic for interest rate bulls. And a 72% chance of a 50 basis point cut is even more aggressive. Right now, I’d put the odds of a cut of any magnitude between 50% and 75% based on what Bernanke has said and done so far.

I bring this up not because I think people should speculate in the futures markets, but because it’s important to understand what is currently priced into the marketplace. If we don’t get a cut later this month, which I think is certainly more probable than the markets currently are telling us, then stocks are going to sell-off. That is what we open ourselves up to when the market prices in something as a certainty even though there is still an undeniable fact that nothing is certain about the September FOMC meeting.

And even if we do get a cut of 25 basis points, we could still see the market not react positively because more than half of people right now expect 50 basis points (who knows what that number will be at meeting time). Just be aware that the risk-reward trade off right now in the short term doesn’t appear all that favorable as long as you assume two things. One, the fed fund futures market accurately gauges what the market is currently pricing into prices. And two, the market will be reacting to interest rate speculation and action in coming weeks.