Traders are pricing risk of first half-point Fed hike since 2000

While a quarter-point increase is still the most likely scenario, swap markets are now pricing in more than 25 basis points of tightening by the end of March.
Image: Samuel Corum/Bloomberg

Money markets are reflecting increased speculation that the Federal Reserve might opt for its first super-sized boost to borrowing costs in more than two decades.

While a quarter-point increase is still the most likely scenario, swap markets are now pricing in more than 25 basis points of tightening by the end of March. With no move anticipated at this month’s meeting, that suggests traders are at least contemplating the possibility of a 50-basis-point hike in March. The Fed hasn’t tightened that much in one shot since May 2000, when its tightening cycle was already well underway.

An increased drumbeat around the prospect of a bigger hike in recent days may have added fuel to the selloff in Treasury markets Tuesday that caused benchmark yields to surge. JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon last week warned that Fed tightening might not be as “sweet and gentle” as some expect, while billionaire investor Bill Ackman said the Fed should raise its key interest rate by 50 basis points in March to “restore its credibility.”

The Federal Open Market Committee “needs to prepare the public for the possibility that they will tighten by 50 basis points in March,” wrote William Nelson, chief economist at the Bank Policy Institute and a former Fed staffer.

The central bank is behind the curve, according to Nelson, and so must be prepared to tighten faster if needed. It should also avoid getting locked in to a path by allowing the market to become convinced hikes will only be gradual, he wrote in a note Tuesday.

Leading into this week, the latest positioning data from the Commodity Futures Trading Commission showed that hedge funds extended net eurodollar short positions to the most since December 2018, while further out on the curve speculators are now the most net short 10-year note futures since February 2020.

In the eurodollar market, strategies that protect against Fed hikes have been in demand, with options volumes running at higher than usual levels. Positions have notably amassed in the June options contract, which stand to pay-out should the Fed lift rates by 50 basis points at the March meeting.

Fed-related swaps currently show around 28 basis points of tightening for March and about a full percentage point for the whole of 2022.

“If inflation gets out of control, the Fed may have to hike more than 4 times and could even consider rate hikes of 50 bps instead of the 25 bps in our baseline scenario,” Philip Marey, senior US strategist at Rabobank, wrote in a note. “Unless we see a setback in the real economy, we expect the Fed to hike each quarter this year.”

© 2022 Bloomberg

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