Markets Price in 80% Chance of a Rate Cut at FOMC Meeting

In a stunning reversal of fortune, markets are now beginning to digest the news of a financial world without storied investment banks Lehman Brothers and Merrill Lynch. Fed Funds Futures are now pricing in an 80% chance that the Federal Reserve will cut 25 bps cut at Tuesday's FOMC meeting.

This is a marked contrasted from yesterday's 88% expectation that the Federal Reserve would hold the fed funds rate at 2.00%.

The U.S. financial crisis severely deteriorated on Sunday night when one of the world's biggest banks filed for bankruptcy and another was sold to the Bank of America. Lehman Brothers Holdings Inc, founded in 1850, filed for Chapter 11 Bankruptcy just after midnight EDT. The filing, which will not include its broker-dealer subsidiaries or other units, including Neuberger Berman, marks the first bankruptcy of a Wall Street firm in nearly 20 years.

For the year end meeting scheduled for Dec. 16, markets are now pricing in a 51.4% of a 25 bps rate cut although the probability of a 50 bps rate cut has increased to 34.1% from no chance a week ago.

RBC Capital Markets Fixed Income Strategist T.J. Marta said the Federal Reserve should take immediate action and cut rates by 50 bps.

"We believe that the gravity of the situation requires a Fed ease of 50bp and a removal of the current 25bp premium of the discount rate over the Fed Funds rate," Marta wrote in note to clients. "Such a move would put the Fed 'ahead' of the market, which is already pricing a 25bp ease. A 25bp cut runs the risk of the Fed getting behind the curve, as the market could rapidly price in more cuts should the situation deteriorate further."

For the meeting scheduled for Oct. 29, markets are now expecting a 9.6% chance that Federal Reserve may cut rates by 50 bps, an increase no chance yesterday. The implied probability is factoring in a 72.8% chance of a 25 bps rate cut.

All data taken at 9:25 a.m. EDT

By Steve Stecyk and edited by Stephen Huebl
©CEP News Ltd. 2008