Some extreme views in the market suggest the Fed is likely to raise rates in September ……
It’s a highly unlikely speculation at best, but one that is popular among some veteran bond traders – a bet that the Fed’s next interest rate move could be a hike rather than a cut.
The bet came in the wake of the strong nonfarm payrolls report on Jan. 10, which contrasted with the general consensus on Wall Street for at least one rate cut. This contrarian bet remains in place even after last Wednesday’s modest inflation report reinforced the Fed’s stance on rate cuts and caused yields in the U.S. Treasury market to retreat from multi-year highs.
Based on options tied to the overnight funding rate and analysis in the foreign press as of last Friday’s close, traders now see about a 25% chance of a Fed rate hike before the end of the year. This probability was as high as 30% prior to the release of the CPI data. More than two weeks ago, a rate hike wasn’t even on traders’ minds, with 60% of options traders betting on further Fed rate cuts and 40% betting on a pause.
Like so much in today’s financial markets, this is effectively a policy bet on the incoming Trump administration, and hinges on the idea that tariffs and other policies implemented by the new administration will trigger a rebound in inflation, forcing the Fed to awkwardly change its stance.
Phil Suttl, a former New York Fed economist who now runs his own consulting firm by the same name, now expects the Fed to raise rates in September. “I don’t think they’re going to cut at all. That’s not a crazy view,” he said in a podcast on Friday.
Options trader sees 25% chance of Fed rate hike this year
Suttl expects Trump, who will be inaugurated on Monday, to push through tariffs and restrict immigration, pushing up inflation. He says wages in the U.S. are already starting to rise again.
For now, Suttl’s views remain extreme, as bond traders are already fully pricing in one 25 basis point rate cut from the Fed this year, putting the probability of two rate cuts this year at about 50 percent, and last Thursday, Fed Governor Waller said policymakers could cut rates again in the first half of 2025 if inflation data continues to be favorable.
This comment led to a drop in US Treasury yields. Early last week, the yield on the benchmark 10-year U.S. Treasury note hit 4.81 percent, its highest level since late 2023. Long-term U.S. Treasury yields have been rising since the Fed began cutting interest rates in September.
Roger Hallam, head of global rates at Pioneer Group, said, “If there is a significant inflation surprise in the coming months, the market may start to price in the possibility of a rate hike this year.”
After last December’s meeting, Fed Chairman Jerome Powell told reporters that the Fed was not prepared to accept inflation above its 2% target. When asked if that meant they couldn’t rule out a rate hike in 2025, he said, “You don’t completely rule out or affirm anything in this world.” However, he added that a rate hike “seems unlikely.”
While the bar for a rate hike is high, the Fed has changed course quickly before. In 1998, officials cut rates three times in rapid succession to stem the financial crisis triggered by Russia’s debt default and the near-collapse of Long-Term Capital Management (LTCM). Then, in June 1999, the Fed began raising rates in an effort to curb inflationary pressures.
Tim Magnusson, chief investment officer at hedge fund Garda Capital Partners, said, “For the market to really expect a rate hike, inflation would have to really pick up, say a rise in the CPI to 3%, but right now I think the Fed is more than happy to hold the line for now.”
Benson Durham, head of global asset allocation at Piper Sandler and a former Fed economist, said the probability of betting on at least one Fed rate hike this year in money market options was slightly less than 10% after adjusting for term premiums. He said:
"Overall, the market seems fairly balanced in terms of how it views the risk of a rate hike or a rate cut."
