Fed: The big reversal – Wall Street doesn’t even rule out an interest rate hike – Economic Mail

The world of markets may have been moving for the last time on the pace of an imminent reduction in interest rates by the central bank – signal, the Federal Reserve, but in the last few days something has changed. And this was of course seen in the falling streak that preceded it on Wall Street, essentially testifying to this change.

Now, not a few traders have started betting that the Federal Reserve could raise interest rates again. A hitherto unthinkable prospect that underscores a shift in market expectations following stronger-than-expected US economic data and hawkish comments from policymakers.

Options markets now estimate a roughly one-in-five chance of a U.S. rate hike within the next 12 months, up sharply since the start of the year, analysts said.

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The shift in expectations hit bond markets, with interest-sensitive two-year bond yields – which move inversely to prices – hitting a five-month high of 5.01%. Meanwhile, Wall Street posted its longest losing streak in 18 months before rebounding on Monday (22/4).

The basic scenario

Of course, traders’ base case scenario is for one or two rate cuts of a quarter of a percentage point each this year, down from the six or seven they estimated in January, according to futures market pricing.

But after three months of higher-than-expected US inflation data, investors in one corner of the options market are beginning to take seriously the possibility – floated earlier this month by former US Treasury Secretary Lawrence Summers – that the the Fed’s next interest rate move could even be an increase.

“At some point, if the data continues to disappoint, then I think the Fed will have to start looking at hikes again,” said Richard Clarida, a Pimco economic adviser who was previously a U.S. central bank vice chairman.

Clarida added that a rate hike was not his baseline scenario, but was a possibility if core inflation climbed above 3 percent. So did Greg Peters, co-head of investments at PGIM, who recommended that factoring in a rate hike is entirely appropriate.

Uncertainty

The Fed raised interest rates aggressively between March 2022 and July 2023 in an effort to tame inflation. Interest rates have since ranged from 5.25% to 5.5%, with John Williams, president of the New York Fed, saying last week that the current state of the US economy means there is “no urgency to cut interest rates ». “If the data tells us we would need higher rates to meet our targets, then obviously we will,” he added.

Options pricing reflects a roughly 20 percent chance of a rate hike this year, according to Ed Al-Hussainy, chief interest rate strategist at Columbia Threadneedle Investments. His analysis was based on options that will pay off if the Overnight Covered Rate rises, a money market benchmark that closely tracks the Fed’s borrowing costs.

For his part, Benson Durham, head of global policy and asset allocation at Piper Sandler, said his analysis suggested a nearly 25% chance of rate hikes over the next 12 months, while a PGIM analysis of options data from Barclays showed 29% chance of such an increase in the same time period.

It is worth noting here that at the beginning of 2024 the probability was less than 10%. However, while investors use options to hedge or profit from the possibility of interest rate hikes, a rapid series of cuts also remains a possibility. It’s no coincidence that the options market is pointing to a roughly 20% chance the Fed will cut borrowing costs by as much as 2 percentage points – or eight cuts – over the next 12 months, according to Durham.

“There’s a lot of uncertainty,” Durham said. “My base case has been similar to the Fed’s base case over the past 18 months, but I can also see it tapering much faster under certain scenarios. I can also see them, for various reasons, going ahead with another increase,” he added.