The uncertainty surrounding the Federal Reserve's interest rate decision this week has reached its highest level since 2007, with a more significant rate cut potentially driving the dollar to new lows, but it may also present a buying opportunity...

Since the outbreak of the financial crisis, bond traders have never been so deeply divided on the Fed's next policy decision.

With just two days left before the Fed announces a rate cut, the U.S. interest rate market is in dispute over whether it will cut by 25 basis points or 50 basis points.

According to data compiled by Bloomberg, aside from the Fed's emergency rate cut in March 2020 during the pandemic outbreak, this is the greatest skepticism among interest rate swap traders regarding any scheduled Fed meeting decision since 2007.

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The analysis is based on the difference between the swap rate and the final decision rate.

Policymakers at the Fed are almost certain to cut rates this week, marking its first rate cut since 2020.

However, before entering the quiet period on September 7th, they assessed whether the risk of further weakening in the labor market necessitates a rate cut beyond 25 basis points, which could potentially reignite inflation.

Last week, several media reports cited former Fed officials saying that the Fed should take more aggressive rate cut actions, and subsequently, the market's expectations for a rate cut have significantly increased.

On Monday, CME's FedWatch showed that traders believe the probability of the Fed cutting rates by 50 basis points this week jumped from 50% on Friday to 63%.

Swap pricing tied to the Fed's interest rate decision this week reflects that the Fed will lower the current effective federal funds rate of about 5.3% by 37 basis points, indicating that the divergence still exists.

The market also expects the Fed to cut rates by 117 basis points this year, suggesting that traders expect the Fed to cut rates by at least 50 basis points at least once this year, even if not this week, it will be in the remaining two meetings in November and December.

Former New York Fed Chairman and Bloomberg Opinion columnist Dudley reiterated his support for a 50 basis point rate cut on Monday.

Meanwhile, the Fed's shift comes against the backdrop of increasing political tensions in the U.S., with less than two months to go before the presidential election.

Three Democratic senators urged the Fed to actively lower the benchmark interest rate, including a 75 basis point cut this week, to protect the U.S. economy from potential damage.

As the Fed's easing cycle approaches, the U.S. dollar index fell on Monday, close to its lowest level of the year, continuing the depreciation trend of the past month.

Depending on the scale of the Fed's rate cut, the dollar may ultimately weaken further, but this could also be a buying opportunity.

Joe Tuckey, head of foreign exchange analysis at Argentex, a London-based currency risk management and payment solutions provider, said that a more significant rate cut by the Fed this week "is likely to push the dollar to new lows," while a modest 25 basis point rate cut "could significantly reduce currency volatility."

One reason he holds this view is that "essentially, the necessity for a more significant rate cut indicates concerns about growth and future economic difficulties."

The uncertainty surrounding the scale of the Fed's first rate cut is increasing.

Considering that officials have been trying to communicate in a clear manner in the past, and its two-day meeting will start on Tuesday, this is an unusual development.

Mark McCormick, a strategist at TD Securities, said, "The Fed appears ready to start cutting rates, with the main question being whether the cut is 25 or 50 basis points."

Speaking about the Fed's interest rate forecasts, the team said, "While the Fed's dot plot and rhetoric should dominate the trading around this policy meeting, we firmly believe that data will be more important than words in the weeks and months ahead."

These strategists also said that the dollar is "closely tracking" U.S. economic growth indicators.

McCormick and other strategists wrote in a report on Monday, "TD Securities' discussions with clients often focus on whether the dollar has further room to weaken when the Fed starts cutting rates, or whether this is a buying opportunity as the narrative shifts.

We are in the latter camp for the next few months."

The firm believes that the Fed should start with a 25 basis point rate cut and proceed with caution.