Bond traders increased bets on a July rate hike ahead of the release of U.S. inflation data and the Federal Reserve chair’s speech, as those developments could further reinforce the need for action.
The expectation of rising interest rates is evident in both interest rate options and U.S. Treasury markets. The implied probability of a 25-basis-point rate hike later this month in the interest rate options market has risen from less than 10% to around 50%. The yield on two-year U.S. Treasuries, which is more sensitive to Federal Reserve rate changes than longer-term bonds, held above 4.25% on Tuesday, with the gap over the policy rate continuing to widen.
Ed Al-Husseini, portfolio manager at Columbia Threadneedle, said: “There is a strong likelihood of a rate hike in July.” Although the Federal Reserve’s inflation target stands at 4.1%, slightly below May’s consumer price index, he believes “we need some luck to bring inflation back down to around 2%.”
These moves have accelerated after Christopher Waller, a Federal Reserve governor who until recently was one of the central bank’s most dovish officials, said that interest rate hikes should be considered “in the near term” if inflation data show core prices (excluding food and energy) “rising again.”
On the data front, the U.S. consumer price index for June is expected to show the first decline in both overall and core inflation rates since January. In May, these two rates stood at 4.2% and 2.9%, respectively.
Federal Reserve Chair Kevin Warsh has declined to make predictions about the Fed’s policy direction, adding to their pressure. Warsh, who took office in May, will testify before Congress on Tuesday and Wednesday regarding the Fed’s twice-yearly monetary policy report.
Market expectations for recent Federal Reserve rate hikes surged, pushing interest rate futures higher and increasing the number of open contracts in August federal funds futures. In July, traders’ held contract volume rose by about 23%. The open interest data, released after market close, may rise further based on Monday’s trading activity.
