Traders are starting to consider even bigger rate hikes from the Fed after the hot CPI

(Bloomberg) — Interest rate traders are now betting that the Federal Reserve will raise its benchmark interest rate by at least three-quarters of a percentage point next week, with some saying the hike could be even bigger after consumer price inflation the data is hotter than expected.

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Investors are also raising expectations for how high they think the central bank may eventually raise interest rates in early 2023 – to around 4.3% – although there appears to be growing concern over whether this could also limit economic activity by way, forcing them to ease policy again before the end of 2023. Fed meeting date swaps suggest the benchmark will fall back to less than 3.8% by the end of that year.

Meanwhile, the September 2022 overnight index swap contract rose to 3.14% at one stage on Tuesday, about 81 basis points higher than the current effective fed funds rate, suggesting a minimum of 75 basis points of tightening is underway as a lock for next week. It also suggests some chance that officials could seek a full percentage point hike, and some analysts have begun to shift their views on that scenario. With Fed officials on hiatus ahead of the meeting, however, there is little chance the central bank will formally lay the groundwork for such a change, so all eyes will be on market and media sentiment.

Treasury yields jumped across the curve, with the two-year yield jumping as much as 21 basis points to around 3.78%, the highest level since October 2007. The yield on the 30-year note rose about six basis points to 3. 57%, a level last seen in 2014 and trading below the rates offered by five-year bonds. The yield on the benchmark 10-year note rose as much as 10 basis points to 3.46 percent, while the dollar rose against its major rivals and U.S. stocks fell.

The U.S. consumer price index rose 0.1 percent from July after being unchanged the previous month, Labor Department data showed on Tuesday. From a year earlier, prices rose 8.3%, a slight slowdown, largely due to recent declines in gasoline prices.

The so-called core CPI, which strips out the more volatile food and energy components, advanced 0.6 percent from July and 6.3 percent from a year ago. All measures are above forecasts.

“There’s no question the market is wrong here,” said Gregory Faranello, head of U.S. fixed income trading and strategy at AmeriVet Securities. “The Fed goes to 75bps next week and the question is do we go to 4.5% or more? It keeps the heat on the Fed and the market. In the grand scheme of things, rates are still low.”

Both five-year and 10-year real yields rose to 1% for the first time in more than three years, suggesting continued tightening of financial conditions. Meanwhile, the inversion of the 5- to 30-year nominal curve shifted to its most inverted level in months.

According to Mark Hamrick, senior economic analyst at Bankrate Inc., the rate hike, combined with the shrinking of the central bank’s massive balance sheet, “will act to further slow economic activity and likely weaken the labor market.”

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Traders are once again pricing in the prospect that the Fed will have to cut its benchmark interest rate by half a percentage point from its expected peak before the end of 2023. The pricing shows concern that the rate hikes the Fed is likely to implement to tackle inflation, it could also push the economy into recession and necessitate renewed policy easing.

For now, however, the policy moves seem firmly set and the immediate debate will be on the size of this month.

“Don’t be surprised if the Fed’s hand is forced” and they end up doing 100 basis points of tightening, said Nisha Patel, director and portfolio manager of fixed income at Parametric. “The idea that inflation has peaked has been dispelled and now the likelihood of that soft landing for the economy has only diminished. Expect long-term bond yields to fall ahead of the September meeting as the risk of a recession increases.”

Economists at Nomura were among those who changed their views after the CPI report, saying they now expect a move of 100 basis points this month and a final rate of 4.50% to 4.75% by February 2023.

“It is increasingly clear that a more aggressive path of raising interest rates will be needed to combat the strengthening inflation stemming from an overheating labor market, unsustainably strong wage growth and higher inflation expectations,” they write.

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