The Zhitong Finance App learned that when the Federal Reserve is about to announce the interest rate decision on Wednesday, bond traders have almost decided that the interest rate hike will be the final result. Interest rate swaps linked to the date of the Federal Reserve meeting show that the market currently expects the probability that Federal Reserve Chairman Walsh and his colleagues will raise the benchmark interest rate by 25 basis points is about 94%, which is equivalent to the tightening margin of about 23 basis points already included in the market.
Currently, the US federal funds rate target range is 3.50%-3.75%. If the Federal Reserve raises interest rates by 25 basis points according to market expectations, the policy interest rate range will rise to 3.75%-4.00%. Historical experience shows that when the market's expectations for rate hikes reached current levels, the Federal Reserve almost never let traders down. According to data compiled by Bloomberg since 2008, whenever the probability of implied interest rate hikes in the market reached such a high level, the Federal Reserve eventually raised interest rates.
Based on federal funds futures data, Deutsche Bank strategists further pointed out that if the Federal Reserve unexpectedly chose to stay on hold on Wednesday, it would be the “biggest dovish accident” at regular policy meetings since 1994 when the Federal Reserve began officially announcing interest rate decisions after interest rate meetings ended.
Caesar Maasry, head of investment research at Lunate, said: “The market is unprepared to keep interest rates unchanged or dovish interest rate hikes.”
Probability of interest rate hikes rises to 94% Wall Street turns collectively after inflation data
The market's expectations for the September rate hike have not always been so firm. On the day the Federal Reserve held a policy meeting at the end of July this year, traders only thought the probability of interest rate hikes was about 38%. In the end, the Fed chose to keep interest rates unchanged. Since Walsh remained somewhat vague about how to deal with inflation, long-term US Treasury bonds were clearly sold off at the time.
But this time the situation is quite different. Expectations for the September rate hike have increased markedly since last month. At the time, Walsh said that the Federal Reserve will ensure that inflation cools down “fast enough,” and the market is therefore beginning to increase its bets on further tightening monetary policy.
By Friday, after US consumer price data was released, traders were almost entirely betting that the Federal Reserve would raise interest rates in September. The data shows that US inflation still shows no obvious signs of cooling, and the inflation rate has been higher than the Federal Reserve's target for five consecutive years.
After the data was released, a number of large Wall Street financial institutions quickly revised their interest rate forecasts and adjusted the “stand still” for September as originally anticipated to raise interest rates by 25 basis points. This has further raised the market's implied probability of interest rate hikes to the current level of about 94%.
Walsh changes the way the Federal Reserve communicates and the risk of accidents has increased
For a long time, the Federal Reserve usually tried to avoid surprising the financial market with interest rate decisions, especially when raising interest rates, because a sudden tightening of monetary policy could cause sharp fluctuations in the bond, stock, and foreign exchange markets.
However, since Walsh became the chairman of the Federal Reserve in May this year, uncertainty about policy decisions has increased. Walsh changed the method of communication that the Federal Reserve implemented for a long time in the past, and no longer clearly signals the next policy action to the market in advance as before. This means that even if the market forms highly consistent expectations, traders will still have to face the possibility that policy decisions will be unexpected.
The July policy meeting was a clear example. At that time, until the day the resolution was announced, the market still included a 38% chance of raising interest rates, but in the end, the Federal Reserve did not act.
However, compared with July, the current market's confidence in raising interest rates is clearly higher. An implied probability of 94% means that for the vast majority of bond traders, Wednesday's question is no longer “whether the Fed will raise interest rates,” but more about what kind of policy signal will Walsh release after the rate hike.
Some traders guard against a surge in demand for “black swan” short-term interest rate options
Although interest rate hikes have almost been fully measured by the market, some investors are still hedging against the Federal Reserve's unexpected standstill.
On Tuesday, demand for short-term interest rate options that can profit when the Federal Reserve unexpectedly keeps interest rates unchanged increased dramatically, indicating that there are still traders willing to pay the costs to prevent low-probability events.
The reason is that if the Federal Reserve actually keeps interest rates unchanged when the market has taken into account the probability of an interest rate hike of about 94%, its impact on asset prices may far exceed that of ordinary policy meetings. On the one hand, short-term US bond yields may decline rapidly; on the other hand, since the market is already highly convinced that the policy will be further tightened, the unexpected suspension of interest rate hikes may also be interpreted as an obvious shift in dovish policy.
Therefore, even if the probability of this happening is low, potential market fluctuations are still enough to attract some investors to protect in advance.
Soaring oil prices heighten concerns about inflation, 10-year US Treasury yields rose to their highest level since 2007
This meeting of the Federal Reserve is particularly critical for the bond market, as long-term interest rates in the US have risen to unusually high levels in nearly 20 years.
On Tuesday, 10-year US Treasury yields rose to their highest level since 2007. The recent sharp rise in oil prices has further exacerbated market concerns about rising inflation again, and has also prompted investors to re-evaluate the future path of the Federal Reserve's interest rate.
Higher energy prices may be transmitted to overall prices through gasoline, transportation, and corporate production costs. If inflation continues to be above target, not only may the Federal Reserve need to raise interest rates in September, but the market may also further raise expectations for subsequent interest rate hikes.
As a result, for the bond market, Wednesday's policy decision itself is only the first level of risk. More importantly, will Walsh suggest that this rate hike is just a separate act or part of a new cycle of austerity.
Alex Cohen, FX strategist at Bank of America, said, “Tomorrow's Federal Reserve meeting will be our most important in a while. With the market already accounting for a 90% chance of interest rate hikes, it would be almost unprecedented for the Fed to choose to stay on hold at this point.”
Market focus shifts to policy path after interest rate hikes
The Federal Reserve meeting also had an unusual political context.
US President Trump personally nominated Walsh as Chairman of the Federal Reserve, but during the tenure of former Chairman Powell, Trump publicly demanded that the Federal Reserve cut interest rates drastically several times. Today, after Walsh is in charge of the Federal Reserve for only a few months, the market is almost certain that the central bank will raise interest rates further, making monetary policy clearly in contrast to Trump's long-standing position on low interest rates.
As far as the market is concerned, if the Federal Reserve raises interest rates by 25 basis points as scheduled on Wednesday to actually determine the next phase of US debt, the US dollar, and even US stocks, it will probably be Walsh's statement on the next policy path.
With inflation still stubborn, rising oil prices further increasing price pressure, and 10-year US Treasury yields rising to the highest level since 2007, investors will focus on whether the Federal Reserve will continue to emphasize fighting inflation, and whether there is still a possibility of further interest rate hikes during the year.
Judging from the current probability of an interest rate hike of about 94%, the 25 basis point rate hike itself has been highly digested by the market. In contrast, if the Federal Reserve unexpectedly stands still, or if Walsh sends a clear signal of bias, it may become the biggest market risk at this meeting.