Betting that the United States Federal Reserve may increase interest rates has been amped up by traders, a notion previously deemed far-fetched. This shift in market predictions closely follows an unanticipated strengthening of US economic indicators, coupled with foreboding statements from decision-makers.
Currently, options markets imply a probable 20% chance of a US rate hike within the ensuing year, portraying a noticeable surge from the beginning of this year as indicated by industry analysts.
These shifting anticipations have impacted bond markets, evidenced by interest rate sensitive two-year Treasury yields, which fluctuate in the opposite direction to prices, attaining a peak of 5.01%, unseen for five months. After suffering the longest loss run in a year and a half, Wall Street shares finally saw a surge on Monday.
Based on predictions seen in the futures market, traders project one or two rate reductions of 0.25% each this year, a marked decline from the six or seven originally envisaged in January.
However, following three consecutive months of US inflation rates surpassing expectations, options market investors are starting to view the likelihood of a rate increase, as posited by former US Treasury Secretary Lawrence Summers, with more seriousness.
“Should the data keep underperforming, I foresee the Federal Reserve revisiting the issue of hikes,” says economic adviser Richard Clarida, formerly vice-chair of the US central bank, from Pimco. While he doesn’t view a rate rise as his primary prediction, Clarida believes it’s a possibility should core inflation exceed 3%.
Economists are predicting that the core personal consumption expenditures, a measure of inflation tracked by the Fed, to be around 2.7% upon the release of March’s data on Friday.
“It’s absolutely reasonable to incorporate a rate rise into predictions,” says co-Chief Investment Officer of PGIM Greg Peters. He is more at ease with the market making room for rate increases, compared to the beginning of the year when it was focused on rate cuts alone.
Between March 2022 and July 2023, the Federal Reserve strived to control inflation, raising interest rates significantly. Since then, interest rates have ranged between 5.25% and 5.5%.
John Williams, president of the New York Fed, recently expressed that the US economy’s current condition currently doesn’t warrant a significant rush to slash interest rates. However, should data indicate a need for raised rates to meet Federal goals, such action would be considered. Options pricing analysis reveals approximately a 20% probability of increasing rates this year, concludes Ed Al-Hussainy, a rates expert at Columbia Threadneedle Investments. This estimation relies on options likely to yield returns due to the rise in the closely followed Fed borrowing rate – the Secured Overnight Financing Rate.
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In a parallel vein, Benson Durham from Piper Sandler, an organisation focused on global policy and assets, suggests there is almost a 25% chance of rate increases in the year ahead. Additionally, Barclays options data analysis from PGIM, indicate a 29% chance for such a rise in the same timeframe. However, in early 2024, such likelihood was under 10%.
Despite predictions pointing to potential rate increases, a quick series of cuts could still occur, serving as a protective or profitable measure for investors. The probability of the Fed reducing borrowing costs by about 2 percentage points (or eight rate cuts) over the next 12 months is close to 20%, per Durham.
Reflecting on the unpredictable nature of the situation, Durham remarked, “I’ve held a viewpoint similar to the Fed’s for the last year and a half. Still, under specific circumstances, I can envision them making rapid cuts, or alternately, adding an extra portion for various reasons.” Please note this content is under copyright from The Financial Times Limited, 2024.