Markets Adjust to Prospect of Aggressive Fed Rate Hikes

Federal Reserve Rate Hike Odds Rise as Traders Hedge Against Interest Rate Increases

Bond traders are increasingly betting that the Federal Reserve will raise interest rates rather than cut them in the near future. According to market data, there is now more than a 50% chance that the Fed will hike rates by next April, before easing. This shift in market sentiment comes as policymakers appear divided over the interest-rate outlook, just before Kevin Warsh takes over as Fed Chair.

Lawrence Gillum, chief fixed-income strategist at LPL Financial, believes that the chances of a rate cut this year are decreasing as the Iran conflict continues. Gillum notes that Warsh has a tough road ahead. The wagers, seen in both futures and options linked to the Secured Overnight Financing Rate (SOFR), are gaining traction ahead of Friday's US employment report. The data could show conditions in the labor market stabilizing, allowing inflation risks to take center stage among investor concerns.

In the swaps market, the odds of lower rates have been pushed out to early 2028, with the March 2028 Fed swap price trading eight basis points below the current Fed effective rate. The pain in the SOFR futures market can be seen in the June 2027 contracts, which have been underperforming over the past couple of weeks as traders have not priced in the potential of interest rate increases until about a year out.

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Market Positioning Indicators

The buildup in shorts comes as the yield on the 30-year US government debt is hovering around 5%, after breaching the key level for the first time this year. In the cash market, a bearish shift was seen over the past week, with a survey of JPMorgan clients showing investors adding to short positions, coming out of neutral.

Market Outlook

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While some analysts, such as Evercore ISI senior economist Marco Casiraghi and analyst Gang Lyu, still believe that the war could delay but not derail rate cuts, the market positioning indicators suggest a growing shift towards a rate hike scenario. As Brij Khurana, portfolio manager at Wellington Management, notes, the front end of the US curve has not engaged substantially with the prospect of a hiking cycle in the next six to twelve months.