Again, Traders Are Betting That The Fed Will Raise Rates

Bond traders are again pricing in greater-than-even odds of the Federal Reserve raising rates next week, after reversing much of the historic decline in yields on Monday, which was fueled by speculation that a spate of bank failures in the past week would prevent the Fed from raising interest rates.

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This repricing had been underway before the release of the February inflation data, which was mostly in line with expectations, and the release of these data had a little immediate effect on the repricing. However, despite a 61 basis point decline in the two-year Treasury yield on Monday, the yield hit a session high near 4.40% in New York in the early afternoon, up by 41 basis points on the day, following a plunge of 61 basis points on Monday.  

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At the close of the market on Monday, swaps traders upgraded the odds of a Federal Reserve rate hike next week from around 50% to around 80%. While the core consumer price index rose slightly more than economists estimated, it still shows slower year-over-year growth compared with January, so those odds only briefly edged higher after the core consumer price index rose slightly more than economists expected. 

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“Given the way the financial markets are performing early today, in conjunction with the data, there is a good chance that a 25 basis point hike will take place in March, but only on the margins,” said Alan Ruskin, chief international strategist at Deutsche Bank.

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A seismic shift has occurred in the Treasury market in the past week, with the yields of two-year bonds reaching a multi-year high on Wednesday at 5.08%, after Fed Chair Jerome Powell said he would be open to accelerating rates from January's quarter-point hike as soon as economic data warranted it.

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In early European trading on Monday, the two-year yield dipped below 4% as investors continued to dump US bank shares despite a rescue plan announced by regulators late Sunday. It hit 3.82% in the early hours of European trading, the first time the yield has breached its 200-day moving average since mid-2021. As a result, there has been an increase in bank share prices on Tuesday, with the KBW Bank Index up by more than 4%, bringing its decline since March 6 to about 22%.

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Wall Street banks changed their forecasts for next week's Fed meeting due to the financial turmoil. Nomura Securities predicted a rate cut next week, while Goldman Sachs, NatWest Markets, and Barclays declined to forecast a rate hike in March.

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While this is happening, inflation is continuing to rise much higher than the Federal Reserve's target rate of 2%. It is estimated that the consumer price index rose 6% year-on-year in February, down from 6.4% in January. In spite of the 0.5% rise for the month, the core CPI eased to 5.5% from 5.6%, a tenth more than the economists expected.

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During a Trade Algo interview in which Ethan Harris, head of global economics research at Bank of America Corp., discussed the regulatory response to the bank failures, he said, "Our view is that ultimately the ring-fencing will work, and the Fed will be able to hike interest rates again. Ultimately, it will be up to the Fed to combat inflation in the long run.”