Markets Spent Months Waiting For Rate Cuts. Now They Are Pricing Rate Hikes

The Federal Reserve enters its September meeting with traders assigning roughly an 87 percent probability to a rate increase. Goldman Sachs and J.P. Morgan both changed their forecasts on 14 September and now expect the Fed to raise its policy rate by 25 basis points. J.P. Morgan also expects another increase in December.

Only weeks ago, investors were still debating when the next easing cycle would arrive. Oil above $100 a barrel, stronger US inflation and another rise in long-term bond yields have changed the trade. The European Central Bank has already moved. It raised its main rate from 2.25 to 2.5 percent on 10 September and warned that inflation will remain above target through 2027. The Bank of Japan also enters its meeting with markets expecting tighter policy. Three major central banks are therefore confronting inflation at the same time rather than moving gradually towards easier policy.

The front end has had to reprice first

Interest-rate markets respond quickly when traders change their assumptions about the next policy meeting. The larger portfolio problem sits farther along the curve.

A single 25-basis-point Fed increase does not determine the value of a 10-year Treasury. Investors care about the path of inflation, government borrowing and how long the policy rate stays restrictive. US 10-year yields briefly reached 4.9915 percent last week. German 10-year yields reached their highest level since 2011 after the ECB decision.

Those moves remove one of the assumptions behind expensive equities: that lower interest rates will gradually reduce the discount rate applied to future earnings. A technology company promising most of its profits years from now has to compete with government bonds offering yields close to 5 percent today. Equity investors therefore have a rates position even when they never trade a bond.

Oil has turned from a commodity trade into a rates trade

Brent briefly approached $110 last week before easing. The direct trade appears simple. Supply disruption pushes crude higher, energy companies gain and fuel-sensitive businesses face higher costs. Central banks complicate the picture.

Higher fuel costs enter inflation data, transport expenses and corporate margins. Businesses eventually decide how much of the increase to absorb and how much to pass to customers. Workers watch the cost of essentials when negotiating wages.

The ECB already cited stronger inflation pressure when it raised rates. Oil therefore moves bond yields through the expected central-bank response as well as through headline inflation. A trader long crude and long duration is expressing two views that now work against each other. The oil position benefits from the supply shock. The long-bond position suffers if the same shock keeps policy rates higher.

The yen trade becomes harder if the BOJ keeps tightening

The Japanese yen reached a seven-month high before the latest policy meetings. For years, low Japanese rates made the currency a natural funding leg for carry trades. Investors borrowed cheaply in yen and deployed capital into assets offering higher returns elsewhere.

That structure becomes less attractive as the Bank of Japan raises rates. A stronger yen also increases the cost of closing existing positions for investors who need to buy the currency back. Carry trades therefore unwind through both the interest-rate differential and the exchange rate.

Markets already received a warning in previous bouts of yen strength. Positions that appear diversified across equities, credit and emerging markets sometimes share the same financing exposure underneath.

A faster BOJ tightening cycle raises the value of identifying that exposure before volatility does it for the portfolio.

The next Fed statement matters beyond the September increase

An increase that markets already price heavily does not automatically create a large reaction. The path after the meeting carries more information.

If Fed Chair Kevin Warsh presents September as insurance against another inflation surge, markets have room to keep expecting eventual easing in 2027. A message that persistent inflation requires several increases changes the valuation of bonds, currencies and equities at the same time.

Goldman still expects two cuts in 2027. J.P. Morgan expects another increase this December and raised its estimate of the long-run policy rate to 3.25 percent. Those forecasts disagree less about this week than about where rates settle afterwards. Traders spent much of the previous cycle trying to identify the first cut. The market now has to price the possibility that it declared victory over inflation too early.