Markets bet on sharpest pace of Fed tightening since 1994

Money-market traders are betting the Federal Reserve is heading for its most aggressive monetary policy tightening in almost three decades as it fights a commodity-driven inflation spike.

They are pricing in a further 225 basis points of interest-rate hikes by the end of the year on top of the 25 basis points already delivered in March.

The Fed hasn’t done that much tightening — 250 basis points — in one year since 1994, a famously brutal year for bond investors that even included a 75 basis-point hike. The last year there was more tightening was in the early 1980s, when Paul Volcker was in charge of the central bank.

With US inflation heading for 8%, a rate not seen in 40 years, Fed officials have adopted a decidedly more hawkish tone. The prospect of aggressive tightening has already led to a global bond rout this year, and the latest move in market bets follows comments by Governor Lael Brainard that the central bank will continue tightening monetary policy methodically.

“This boils down to what does Brainard mean by ‘methodical’,” said Marc Ostwald, global strategist at ADM Investor Services.

He says the Fed wants flexibility, but it also doesn’t want to be constantly changing the pace of tightening. Ostwald expects a half-point hike next month and probably in June followed by quarter-point hikes, but the “underlying lack of any depth to liquidity in markets, persistent high volatility will likely take a heavy toll, and by extension the Fed will become wary.”

US Treasuries fell for a fourth day Wednesday, sending the yield on 10-year notes surging as much as eight basis points to a two-year high of 2.63%. That followed Tuesday’s advance which was the biggest since the pandemic first struck in March 2020.

Global peers were caught up in the selloff, and UK and German benchmark borrowing rates jumped as much as nine and six basis points, respectively. Australian peers fared worse, with 10-year yields climbing as much as 13 basis points to just shy of 3%, the highest since 2015.

As the inflation backdrop worsens, Fed Chairman Jerome Powell and various other policy makers have indicated that they are willing to boost US rates in increments of 50 basis points if necessary.

Given there are six scheduled meetings left this year, the current pricing would equate to three half-point hikes and three quarter-point increases, assuming the Fed raises borrowing costs at every decision. That would lift the upper end of the range to 2.75%, a level not seen since the 2008 financial crisis.

However, even this still falls short of some economists’ expectations. Citigroup Inc. last month forecast 2.75 percentage points of increases this year and more in 2023, taking the benchmark rate to a range of 3.5% to 3.75%.

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