Investors weigh increasing likelihood of another Fed interest rate hike

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Investors weigh increasing likelihood of another Fed interest rate hike

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Traders bet that the Federal Reserve could raise interest rates again, a once-unthinkable prospect that highlights a shift in market expectations after stronger-than-expected U.S. economic data and hawkish comments from policymakers.

Options markets now suggest about a one-in-five chance that U.S. rates will rise over the next 12 months, up sharply from earlier this year, analysts say.

The shift in expectations hit bond markets, with yields on interest-rate-sensitive two-year Treasury notes – which move inversely to prices – hitting a five-month high of 5.01 percent. Wall Street stocks suffered their longest losing streak in 18 months before surging on Monday.

Traders mainly expect one or two rate cuts of a quarter percentage point each this year, compared to six or seven in January, depending on prices in the futures market.

But after three months of higher-than-expected U.S. inflation data, investors in part of the options market are starting to take the possibility seriously – suggested earlier this month by former U.S. Treasury Secretary Lawrence Summers – that the Fed’s next rate hike will be higher instead. .

“At some point, if the data continues to disappoint, then I think the Fed will have to start doing rate hikes again,” said Richard Clarida, an economic adviser at Pimco who previously served as a vice chairman at the central bank. American. Clarida added that a rate hike was not its base case scenario, but was a possibility if core inflation returned above 3 percent.

Economists expect core personal consumption expenditures — a gauge of inflation tracked by the Fed — to rise to 2.7 percent when March data is released Friday.

“I think it is entirely appropriate to take into account [a rate increase] said Greg Peters, co-chief investment officer of PGIM. “I feel a lot better about the market valuation compared to earlier this year, where it was just extremis reductions.”

The Fed aggressively raised interest rates between March 2022 and July 2023 in an effort to control inflation. Since then, rates have fluctuated between 5.25 percent and 5.5 percent.

Last week, John Williams, president of the New York Fed, said the current state of the U.S. economy meant he did not “feel the urgency to cut interest rates.” Although this is not his base case scenario, he added that “if the data tells us that we would need higher interest rates to achieve our goals, then obviously we would want to do that.”

Options prices reflect about a 20 percent chance of a rate hike this year, according to Ed Al-Hussainy, rates strategist at Columbia Threadneedle Investments. His analysis was based on options that would pay off if the Secured Overnight Financing Rate rose, a money market benchmark that closely tracks the Fed’s borrowing costs.

Benson Durham, head of global policy and asset allocation at Piper Sandler, said his analysis suggests a nearly 25 percent chance of a rate hike over the next 12 months, while a PGIM analysis of Barclays options data indicates a 29 percent probability. probability of such an increase over the same period.

At the start of 2024, the probability was less than 10 percent.

However, even if investors use options to protect against or benefit from a possible rise in rates, a rapid series of declines also remains a possibility.

The options market suggests there’s about a 20 percent chance the Fed will cut borrowing costs by up to 2 percentage points — or eight reductions — over the next 12 months, according to Durham.

“There’s a lot of uncertainty,” Durham said. “My base case is similar to what the Fed has seen over the past 18 months, but I can also see it tapering much faster in some scenarios. I can also see them, for various reasons, adding another spoonful.

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