Published on May 26, 2023

Fed Traders Set the Stage for an Interest-Rate Hike - What You Need to Know

Traders have already factored in an additional increase of a quarter-point in interest rates by the Federal Reserve in the next two policy meetings. There is a greater than 50% chance that this hike could occur as early as next month.

This change in expectations coincided with the rise in US yields. The two-year rate, which is sensitive to policy changes, increased by 15.7 basis points to reach 4.53%, the highest level since early March. During that time, US bank failures caused market turmoil and led to increased buying of government debt as a safe haven.

Yields at the short end of the curve have been rising for 10 consecutive trading sessions. The recent increase is driven by growing optimism about a potential debt-ceiling agreement and resilient economic data, which could pave the way for further tightening by the Federal Reserve.

The rate on swap contracts linked to the July meeting climbed to 5.37% on Thursday, more than 25 basis points above the current effective fed funds rate. However, it later settled at 5.34% in late New York trading.

Given that the Federal Reserve typically adjusts rates in multiples of 25 basis points, the market sees the possibility of a rate hike occurring either in July or at the Federal Open Market Committee's next meeting in June. The June contract indicates around 14 basis points priced in, suggesting a better than even chance of a hike taking place at that meeting.

Just a few weeks ago, after the central bank's tenth consecutive rate hike, the market was confident that there would be no further increases this year. In fact, there were expectations of up to three rate cuts by the end of the year due to concerns about regional bank failures and indications from some officials suggesting an impending recession.

However, these views have been overshadowed by concerns about persistently high global inflation and tight labor market conditions that have been prevalent earlier this year.

The fear of contagion in the banking system has diminished, and the turmoil surrounding the debt ceiling has not yet triggered significant demand for safe assets, which would push down expected rates.

"The market has been eager to anticipate a pause and even cuts, not necessarily as the most likely outcome, but more due to the risk of an unexpected event that would force the Fed to reverse its course sharply later this year," said Dominic Konstam, head of macro strategy at Mizuho Securities. "So any signs of stability naturally reduce the probability of such a risk materializing."

Federal Reserve officials have recently emphasized their intention to balance the forces of inflation and a strong job market with signs that the ten rate increases over the past 14 months, totaling 5 percentage points, are starting to create financial stress that justifies a pause in June.

Konstam believes that the Fed is unlikely to adopt rate cuts or completely abandon the possibility of further hikes. However, he suggests that currently they are leaning more towards a wait-and-see approach and a pause in June, rather than aggressively moving forward.

Contracts for future periods still indicate the need for rate cuts within the next year, but the anticipated extent of easing has decreased significantly. The swap rate for the December meeting is currently around 4.98%, up from a low of 4.20% earlier this month.

Another indicator suggesting a diminishing expectation of rate cuts in the near term is the narrowing inversion of the yield curve. The yield on the two-year Treasury note is now approximately 0.7 percentage points higher than the 10-year yield, compared to around 0.4 percentage points earlier this month.

The possibility of a renewed demand for Treasuries as a safe haven is also decreasing as Washington seeks to reach an agreement on raising the debt ceiling before the upcoming US holiday on Monday.

House Speaker McCarthy stated that progress had been made in debt-ceiling talks, with negotiators working past midnight on Wednesday. However, there are still unresolved issues, and efforts are being made to find a solution around the clock.

"The market assumes that there will be a debt limit deal without significant spending cuts," said Priya Misra, global head of rates strategy at TD Securities.

However, Misra added that a debt ceiling deal would likely come with spending cuts, which could negatively impact economic growth, in addition to the effects of rate hikes and tightening lending standards by banks. She suggests that the Federal Reserve may raise rates once more, but that would only increase the amount that the Fed would need to cut next year.