Market expectations have swung sharply toward tighter U.S. monetary policy, with implied odds of a Federal Reserve interest-rate increase by September running at about 75% and probabilities of a July hike now above 50%. A dramatic change in sentiment has unfolded over a matter of days: five days ago there was effectively no market-implied chance of any rate increase this year, and traders had been positioned for the Fed's next move to be a reduction in borrowing costs.
As recently as last month, financial markets were pricing in two interest-rate cuts by year-end. That outlook held through the early weeks of the Iran conflict, which began on February 28, when markets generally appeared to be looking past the effect of higher oil prices and continued to expect policy easing. Fed policymakers largely reflected that same view.
The pivot in expectations accelerated this week after the Iran conflict escalated further and Fed Chair Jerome Powell signaled that he did not believe risks to the labor market outweighed risks to inflation. The tone shifted still more on Thursday and Friday, driven in part by comments from Fed Governor Christopher Waller. Waller - a central-bank official previously seen as inclined toward easing - said the risk that the conflict could produce persistent inflation was significant enough to lead him to vote for leaving interest rates unchanged this week rather than supporting cuts he had earlier expected to back.
The market reaction was swift. Equity prices fell while the yield on the two-year U.S. Treasury note - a benchmark that tends to move with expectations for Fed policy - rose noticeably.
This rapid re-pricing highlights the sensitivity of financial markets to geopolitical developments and to shifts in Fed communications. Traders moved from anticipating multiple cuts to assigning meaningful probability to a rate increase within a few weeks, underscoring how quickly expectations can change when inflation risks are perceived to be rising.
Impacted sectors:
- Equities - experienced a pullback as rate-hike odds rose.
- Fixed income - two-year Treasury yields increased in response to shifting Fed expectations.
- Energy - higher oil prices tied to the Iran conflict were a factor in changing inflation risk perceptions.