Financial markets have recently re-evaluated the Federal Reserve's likely policy trajectory, with short-term instruments signaling a notable increase in the chance of a near-term rate hike. Overnight index swaps now price a 10% probability that the Fed will raise rates by April and a 20% probability of an increase by October.
Market participants and analysts pointed to the speed of the reassessment as striking. Mizuho TMT analyst Daniel O’Regan highlighted how expectations have moved in a matter of days: "The most important macro development over the past 24 hours, in my view, has been the sharp shift in rate cut expectations: the market is now pricing a 10% chance of a rate hike in April, up from 6% yesterday and 0% on Wednesday. There is a 0% chance of a cut according to CME futures—quite a reversal from the start of the year when 2–3 cuts were priced."
Two-year Treasury yields have been at the center of this repricing. DoubleLine Capital's Jeffrey Gundlach said the 2 year U.S. Treasury yield "has risen 50 basis points in less than three weeks. It now suggests one Fed HIKE may be coming," and he made that comment on X.
Analysts and investors have linked the rise in short-term yields to higher energy prices stemming from the conflict involving Iran. Those energy price pressures are seen as feeding into broader inflation concerns. Producer price index (PPI) readings released this week were also above consensus expectations, even though the latest data did not yet fully reflect higher crude oil prices.
Federal Reserve Chair Jerome Powell addressed the inflation dynamic at a Washington news conference on Wednesday. He said that "near-term measures of inflation expectations have risen in recent weeks, likely reflecting the substantial rise in oil prices caused by the supply disruptions in the Middle East." He added that "higher energy prices will push up overall inflation," while cautioning that "it is too soon to know the scope and duration of the potential effects on the economy."
The combination of rising short-term yields, elevated PPI readings, and energy market volatility has prompted markets to move away from earlier expectations of multiple rate cuts this year, instead putting a non-negligible probability on at least one hike within the coming months.
Key points
- Overnight index swaps place a 10% chance of a Fed rate increase by April and 20% by October - these shifts alter pricing across interest-rate sensitive markets.
- Two-year Treasury yields climbed about 50 basis points in under three weeks, a move market participants see as signaling possible Fed tightening.
- Higher energy prices from the Iran-related conflict and above-consensus PPI readings have intensified inflation concerns, influencing rate expectations.
Risks and uncertainties
- Persistence of higher energy prices - continued pressure on inflation could affect consumer prices and interest-rate markets, especially energy-intensive sectors.
- PPI momentum - if producer prices continue to surprise to the upside, markets may further reprice rate expectations, impacting fixed income and interest-rate sensitive equities.
- Scope and duration of economic effects - as Fed Chair Powell noted, it is uncertain how long and how large the inflationary impact from supply disruptions will be, creating uncertainty for monetary policy and market positioning.