I spent some time late last week talking about the Fed’s reflexivity dynamic with markets, and specifically with the US rates complex.

One of the many critical nuances of the Committee’s most recent media smoke signals (i.e., articles from Nick Timiraos and Colby Smith, both of whom winked at 50bps when the market had left it for dead) is the extent to which it suggests Jerome Powell’s either leaning strongly in favor of an upsized move this week or else prepared to deal with the fallout from a disappointment of his own making.

Whatever happens on Wednesday, it’s critical for market participants who actively trade (so, traders as distinct from investors) to develop a knack for the psychology of the Fed-STIRs/FI/bonds reflexivity nexus.

Consider this: Market pricing had 25bps as the September FOMC chalk following last week’s CPI update. Dispatching Timiraos, Smith and, later, Greg Ip, to reset that pricing to roughly even odds likely suggested more than even odds of 50. Why? Because the risk associated with wrong-footing a market leaning dovish at a dovish inflection point for policy is substantial: Failing to deliver — which in this case would mean only going 25 — means risking a market reversal that serves to offset the quarter point-cut through higher reals, a stronger dollar and lower equity prices. That risk is amplified in modern markets.

If you’re Powell, you wouldn’t (or shouldn’t) run that risk unless you thought the odds of a 50bps move were quite high. As Conor Sen put it, “55-60% chance of 50bps… probably means more like 85%.”

In a Monday note, Nomura’s Charlie McElligott underscored the point. “Now that the market has priced 50bps, you’re ‘in it,’ or else you create your own massive FCI tightening shock if you disappoint,” he wrote, highlighting the table and charts below (click to enlarge).

On the left, you’re looking at maxed-out CTA longs across STIRs and bonds. On the right is estimated exposure in a historical context.

“Why, at this point, would a ’25bps dovish cut’ trigger a massive FCI tightening?” Charlie wondered, on your behalf, before answering. “Look at the [CTA trend] front-end long across global fixed-income,” he wrote, referencing the table on the left before turning to the charts on the right: “The net exposure across G10 bonds for managed futures is the high[est] since September 2021, and the aggregated net STIRs position is at the highs since March 2021.”

If you’re the Fed and you’re trying to get ahead of nascent labor market softening by dialing back policy restriction, just about the last thing you want to do is encourage already bullish fast-money rates bets only to turn around and wrong-foot them. To do that would be derelict bordering on irresponsible. (Or else just evidence of an incurable penchant for own-goals and clownishness.)

The saving grace for a Fed that still might stumble into a reflexivity mistake is that, as McElligott went on to point out, those positions are so deeply in-the-money — which is to say so far from levels that would trigger CTA deleveraging — that the Fed would have to deliver a dramatically hawkish outcome versus consensus (e.g., 25 with just one additional 2024 quarter-point cut tipped) to engender a mechanical deleveraging.

As Charlie put it, “there is potentially massive-magnitude sell-to-deleverage flow, but you’d really need to shock hawkishly in order to get prices moving substantially [enough] to risk [hitting] those sell triggers.”