Fed traders fully price in an interest-rate hike once again

Traders fully priced in another quarter-point interest-rate increase by the Federal Reserve within the next two policy meetings and a more than one-in-two chance that hike could arrive as soon as next month.

The shift came as US yields rose, with the policy sensitive two-year rate rising 15.7 basis points to 4.53%. That’s the highest level since early March, around the time when US bank failures roiled markets and spurred haven buying in government debt.

Front-end yields have moved higher for 10 straight trading sessions and the latest leg was fueled by increased optimism about a potential debt-ceiling deal and resilient economic data that could pave the way for additional Fed tightening.

The rate on swap contracts linked to the July gathering climbed to 5.37% on Thursday, more than 25 basis points above the current effective fed funds rate, before coming back to 5.34% late in New York.

The Fed tends to move in multiples of 25 basis points, so that indicates such a decision is seen by the market taking place either in July or at the Federal Open Market Committee’s next meeting in June. The June contract showed around 14 basis points priced in, suggesting a better than even chance the hike would take place at that meeting.

As recently as the first week of May, when the central bank raised rates for the 10th straight time, the market had near-total confidence that there would be no additional hikes this year, and that the Fed would cut rates as many as three times by year-end.

That view, which was based on recession risk posed by a spate of regional bank failures and indications from some officials, has been overtaken by concerns about persistently high inflation globally and tight labour-market conditions that predominated earlier in the year.

The threat of contagion in the banking system has ebbed, and the fracas around the debt ceiling has yet to unleash haven demand that could pull expected rates lower.

“The market has been eager to price for a pause and then cut not necessarily as a modal outcome but more about the risk of something suddenly breaking that forces a sharp reversal out of the Fed,” later this year, said Dominic Konstam, head of macro strategy at Mizuho Securities. “So any signs that nothing is breaking obviously makes it easy to scale back the pricing of that risk.”

Financial stress

Fed officials have communicated in recent speeches they are seeking to balance the forces of still-elevated inflation and a resilient jobs sector with signs that the central bank’s 10 rate increases totaling 5 percentage points in the past 14 months are beginning to cause financial stress that warrants a pause in June.

“The Fed won’t feel any need to embrace cuts and they are unlikely to give up on the potential that more hikes are needed,” said Konstam, although he leans to a view that “as of now they are still biased in my view to be more wait and see,” and “pause in June rather than steam roller through.”

Swap contracts further out continue to suggest the Fed will need to cut again within the coming year, but the extent of anticipated easing is considerably less than it was. The December meeting swap is around 4.98% and up from a low of 4.20% earlier this month.

Another bond market proxy showing rate cuts in the near term is waning is a deeper inversion of the yield curve. The two-year yield is now around 0.7 percentage points above the 10-year and this measure has flattened from around 0.4 percentage points earlier this month.

The prospect of a renewed haven bid for Treasuries was also waning as Washington seeks to reach an agreement over raising the debt ceiling before the US holiday on Monday.

“I thought we made some progress” in debt-ceiling talks that had negotiators working past midnight on Wednesday, House Speaker McCarthy told reporters Thursday morning. “There are still outstanding issues. I’ve directed our team to work 24/7 to solve this problem.”

“The market is assuming a debt limit deal and no real spending cuts,” said Priya Misra, global head of rates strategy at TD Securities.

However, “a debt ceiling deal will come with cuts, which will hurt growth, apart from impact of rate hikes and bank tightening of lending standards,” and “maybe the Fed hikes once more, but that’s just increasing the amount the fed will need to cut next year,” Misra added.

© 2023 Bloomberg