Investors are betting the Federal Reserve could deliver an extra-large rate rise next month, or even lift borrowing costs between scheduled meetings for the first time since 1994, as policymakers battle blistering inflation.
Expectations of a more aggressive tightening in monetary policy mounted after Thursday’s US inflation data, which showed consumer prices rising at the fastest annual pace in 40 years and once again confounded forecasts that price pressures would begin to level off.
Investors had in recent weeks coalesced around the view that the Fed will increase interest rates by 0.25 percentage points at its March meeting. However, traders in money markets are now pricing in a more than 50 per cent chance the central bank will boost rates by half a percentage point next month.
Contracts
Futures contracts linked to the federal funds rate – which currently stands at a historic low of between zero and 0.25 per cent – also show the possibility of a move before the Fed meeting that starts on March 20.
“The Fed knows it has to hike rates,” said Gennadiy Goldberg, US rates strategist at TD Securities. “It’s very likely that they will hike faster and probably will hike at consecutive meetings. There are a multitude of arguments for going more quickly and I think the market is realising it.”
Two-year US government debt – which is highly sensitive to moves in short-term interest rates – suffered its biggest one-day sell-off since 2009 on Thursday after the data showed inflation hit 7.5 per cent in January. The two-year yield traded at 1.63 per cent on Friday, leaving it on track for the highest close since late 2019, from 0.4 per cent as recently as November.
James Bullard, one of the Fed’s more hawkish policymakers, fuelled the selling by saying on Thursday he backed a half-point rate rise in March and that the Fed should be open to the idea of responding sooner.
A shift in Fed policy between meetings is rare. The central bank delivered emergency unscheduled rate cuts during the global financial crisis in 2008 and the early stages of the pandemic in March 2020, but has not increased borrowing costs in this way since April 1994.
A move prior to the March Fed meeting would be “out of character” for policymakers who typically try prime markets for policy changes, according to analysts at JPMorgan. “Nevertheless, unless [Fed] leadership pushes back on this notion, markets will continue to price a significant chance of an intermeeting tightening over the near term,” they said in a note to clients.
Transitory
The dramatic rise in yields reflects the “pivot” made by the Fed in December, when Jay Powell backed away from his previous mantra that high inflation was transitory in nature.
Since then, traders have responded to stubbornly high monthly inflation readings by pricing in an increasingly aggressive Fed response. Markets now expect at least six quarter-point rate rises by the end of the year. Goldman Sachs raised its forecast on Thursday to seven increases in 2022.
Some analysts argue that wagers on a sharp rise in borrowing costs could become a self-fulfilling prophecy.
"The Fed has not faced inflation of this magnitude at the start of a hiking cycle for many decades," said Ajay Rajadhyaksha, head of macro research at Barclays, adding that the central bank "has historically been reluctant to shock financial markets going into a meeting."
“If [a half percentage point rise in rates] is priced in with a very high probability just before the March meeting, that might - whether it should or not - have significant influence on the Fed’s decision at that meeting,” he said. – Copyright The Financial Times Limited 2022
