Financial Times: Investors bet on the possibility of another rate hike by the Federal Reserve

Author: Kate Duguid, Harriet Agnew, Financial Times

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

According to analysts, the current options market indicates that the probability of a rate hike in the U.S. within the next 12 months is about one in five, a significant increase from the beginning of the year.

The shift in expectations has impacted the bond market, with the two-year Treasury yield, sensitive to interest rates, reaching a five-month high of 5.01%. Wall Street stocks surged on Monday after experiencing the longest streak of declines in 18 months.

Futures market pricing shows that traders' central expectation is for one to two rate cuts this year, each by 0.25 percentage points, down from the six to seven cuts expected in January.

However, after three consecutive months of U.S. inflation data exceeding expectations, investors in one corner of the options market have begun to seriously consider the possibility that the Fed's next move could be a rate hike. Former U.S. Treasury Secretary Lawrence Summers raised this possibility earlier this month.

Richard Clarida, former vice chairman of the Federal Reserve and now an economic advisor at Pacific Investment Management Company (Pimco), stated, "At some point, if the data continues to disappoint, I think the Fed will have to start raising rates again." Clarida added that a rate hike is not his baseline forecast, but it is possible if core inflation rises above 3%.

Economists expect that the core personal consumption expenditures index for March, a key inflation gauge followed by the Fed, will reach 2.7% when it is released on Friday.

Greg Peters, co-chief investment officer at PGIM, said, "I think it's entirely appropriate to factor in (a rate hike). I feel much better about this being digested by the market compared to just extreme cases of rate cuts at the beginning of the year."

The Federal Reserve aggressively raised rates from March 2022 to July 2023 to curb inflation. Since then, rates have hovered between 5.25% and 5.5%.

Last week, John Williams, president of the New York Federal Reserve Bank, stated that the current economic conditions in the U.S. mean he does not "feel an urgency to cut rates." Although this is not his baseline forecast, he added, "If the data tells us that we need higher rates to achieve our goals, then we obviously want to do that."

Ed Al-Hussainy, interest rate strategist at Columbia Threadneedle Investments, noted that options pricing reflects a roughly 20% chance of a rate hike this year. His analysis is based on options that would be paid if the secured overnight financing rate (a money market benchmark closely tracking the Fed's borrowing costs) rises.

Benson Durham, global policy and asset allocation head at Piper Sandler, stated that his analysis shows the likelihood of a rate hike in the next 12 months is close to 25%, while PGIM's analysis of Barclays options data indicates a 29% chance of a rate hike during the same period.

By early 2024, that probability drops to less than 10%.

However, while investors are using options to hedge against the possibility of rate hikes or to profit from them, a series of rapid rate cuts also remains possible.

Durham believes that the options market indicates about a 20% chance that the Fed will lower borrowing costs by 2 percentage points (i.e., eight rate cuts) within the next 12 months.

"There is a lot of uncertainty," Durham said. "My baseline forecast is similar to the Fed's baseline forecast over the past 18 months, but I can also see them cutting rates faster in certain scenarios. I can also see them raising rates again for various reasons."