Traders start to consider even bigger Fed rate hikes after hot inflation data

NEW YORK – Rates traders are now betting the Federal Reserve will lift its benchmark rate by at least three-quarters of a percentage point next week, with some chatter that the increase might need to be even bigger than that after consumer price inflation data came in hotter than expected.

Investors are also driving up expectations for just how high they reckon the central bank might ultimately push policy rates early in 2023 – towards around 4.3 per cent – although it appears that concern is mounting about whether that could also crimp economic activity in a way that forces it to re-ease policy before 2023 is out.

Swaps linked to Fed meeting dates suggest that the benchmark will be back down to less than 3.8 per cent by the end of that year.

In the meantime, the overnight index swap contract for September 2022 at one stage rose as high as 3.14 per cent on Tuesday, some 81 basis points more than the current effective Fed funds rate, suggesting that a minimum 75 basis points of tightening is seen as a lock for next week.

It also implies some chance that officials could look to lift by a full percentage point, and some analysts have begun to shift their views towards that scenario. With Fed officials in their pre-meeting blackout period, however, there is little chance for the central bank to officially lay the groundwork for such a change, so all eyes will be on sentiment within markets and the media.

Treasury yields jumped across the curve, with the two-year rate soaring as much as 21 basis points to about 3.78 per cent, the highest since October 2007.

Yields on 30-year bonds rose about 6 basis points to 3.57 per cent, a level last seen in 2014, and were trading below the rates offered by five-year notes. Yields on benchmark 10-year notes climbed as much as 10 basis points to 3.46 per cent, while the dollar rallied against its major peers and US stocks dived.

The US consumer price index (CPI) increased 0.1 per cent from July, after no change in the prior month, Labour Department data showed on Tuesday. From a year earlier, prices climbed 8.3 per cent, a slight deceleration, largely due to recent declines in petrol prices.

So-called core CPI, which strips out the more volatile food and energy components, advanced 0.6 per cent from July and 6.3 per cent from a year ago. All measures came in above forecasts.

“There is no question the market is wrong-footed here,” said Mr Gregory Faranello, head of US rates trading and strategy at AmeriVet Securities. “The Fed goes 75 basis points next week and the question is: Are we going to 4.5 per cent or higher? 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 climbed to 1 per cent for the first time in more than three years, suggesting continued tightening of financial conditions. Meanwhile, the inversion of the five- to 30-year nominal curve shifted to its most inverted level, in months.

To Mr Mark Hamrick, senior economic analyst at Bankrate, rate increases combined with the reduction of the central bank’s massive balance sheet “will act to further dampen economic activity and likely weaken the job market”.

Traders are once again pricing in the prospect that the Fed will need to slash its benchmark rate by half a percentage point from its anticipated peak before 2023 is over.

The pricing indicates concern that the increase in rates the Fed is likely to implement to tackle inflation could also drive the economy into recession and necessitate a re-easing of policy.

For now though, the policy moves look to be firmly pointed up, and the immediate debate is set to be over the size of this month’s move.

“Don’t be surprised if the Fed’s hand is forced” and it ends up doing 100 basis points of tightening, said Nisha Patel, director and portfolio manager of fixed income at Parametric. “The idea that inflation had peaked has been dispelled, and now the likelihood of that soft landing for the economy has only decreased. Expect long bond yields likely to come down leading up to the September meeting as recessionary risk increases.”

Economists at Nomura were among those to change their view in the wake of the CPI reading, saying they now expect a 100 basis point move this month and a terminal rate of 4.50 per cent to 4.75 per cent by February 2023.

“It is increasingly clear that a more aggressive path of interest rate hikes will be needed to combat increasingly entrenched inflation stemming from an overheating labour market, unsustainably strong wage growth and higher inflation expectations,” they wrote. BLOOMBERG