Traders expect higher interest rates to remain for the foreseeable future

Ahead of the Federal Reserve’s next move on Wednesday, derivatives markets show the federal funds rate hovering around 3.5% for the long term. This is one percentage point higher than the central bank’s latest forecast. These bets have been rising for most of the year and are now approaching levels not seen since the 2013 bond market rout known as the “Taper Tantrum”.

A long period of rising rates could upset the markets, which have rebounded in recent weeks. Rising rates have penalized once-high-flying tech stocks this year, which had reaped the benefits of near-zero borrowing costs. A longer-term transition to higher rates could mean lower valuations for the tech sector, as well as others where investors expect profits later.

The market supporting these interest rate bets – the five-year and five-year overnight index swap rate – is set by market participants, either by hedging interest rate exposure or by betting on the evolution of the fed funds rate over the five-year period starting five years from now, making it a useful indicator for the future trajectory of Fed policy.

The swap rate rose from less than 1% at the start of 2020 to its highest levels since 2014, towards the end of investors’ multi-month bond-selling spree that followed the central bank’s announcement that ‘it would pull out of bond-buying programs in times of financial crisis. .

The last time the Fed attempted to revive those efforts in 2017, problems in short-term loan markets forced officials to inject emergency liquidity two years later. As the central bank now embarks on another round of such efforts, traders are raising their bets.

Most investors expect Fed officials to raise the benchmark federal funds rate by 0.75 percentage points at the central bank’s November meeting, which would be the fourth straight increase this month. magnitude.

The 10-year Treasury yield rose to around 4% from just 1.6% in January, helping to push the benchmark Bloomberg US Aggregate bond index down more than 15% for the year. The 10-year yield has risen more than 1.4 percentage points since August, its biggest three-month rise since 1984.

Many investors continue to hope that central banks will slow down efforts to fight inflation. After the European Central Bank raised rates by 0.75 percentage points at its last meeting – and several officials expressed a desire for a less aggressive step – bond and futures markets quickly adjusted at a steady pace. slower tightening. Those moves reversed, however, after several European countries reported stubbornly high inflation and policymakers pushed back on the notion that easing was on the table.

Policy rate futures now show fed funds peaking at around 5% around May or June, and staying elevated from there. Earlier in the year, traders had focused on the idea that rates would peak in March, followed by significant rate cuts.

Smaller rate hikes from the Fed may not mark a pivot in policy, Nomura Chief Executive Charlie McElligott said in a Monday note. The biggest change is “a lengthening of the hiking horizon,” he writes.

Key drivers of renewed monetary policy tightening expectations include unusually strong household finances, bolstered by pandemic-induced stimulus. A historically hot labor market is also fueling inflation through wage increases. With few signs of economic or financial malaise, the Fed may have more leeway.

“If nothing is going to break in financial markets, it will take some time to generate enough destruction in the employment landscape to depress consumer demand,” said Bryan Whalen, co-chief investment officer of securities. fixed income at TCW.

A recent New York Fed survey showed that Americans’ median inflation expectations over the next year continue to fall, but longer-term expectations for the next three years have risen to 2.9. %. The latest consumer survey from the University of Michigan showed similar expected price changes, but over the next five to 10 years.

Consumer price index swap contracts do not show headline inflation falling below 2.6% at any time over the next 30 years. These bets have greatly exceeded actual inflation rates this year.

“Unless the Federal Reserve is willing to create a depression, we’re going to have to deal with inflation for at least two to three more years. [tightening] cycles,” said Thomas Tzitzouris, managing director and head of fixed income research at Strategas. “Rate hikes will crush economically sensitive cyclical inflation, but headline inflation of 3% to 4% is structural.

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