Traders are flirting with the idea of a Fed rate hike as January meeting minutes loom

By Vivien Lou Chen

A small probability of another rate hike by the Federal Reserve in the next three months is showing up in options tied to the Secured Overnight Financing Rate, according to Ben Emons of NewEdge Wealth in New York.

It's taken months to sink in, but traders are finally coming around to the once-unthinkable scenario of possibly no rate cuts in 2024 and even considering the idea of another hike by the U.S. central bank.

The readjustment in thinking comes after last week's consumer-price index for January came in hotter than expected and was followed three days later by the producer-price index for the same month, which confirmed that the Federal Reserve's inflation fight isn't over.

A small probability of another Fed rate hike in the next three months is showing up in options on the Secured Overnight Financing Rate, or successor to the London interbank offered rate also known as Libor, according to Ben Emons, senior portfolio manager and head of fixed income for NewEdge Wealth in New York. Meanwhile, Bill Dudley, former New York Fed president, warned in a Bloomberg News column on Monday that current interest-rate levels of between 5.25%-5.5% may not be high enough to restrict U.S. growth.

Read: Inflation data jolted stocks and bonds. This will decide what happens next.

"The market is by some measures 'playing' with the idea that the Fed may have to hike again," Emons wrote in a Tuesday note titled "Flirting Rate Hike."

"The elusive 'last' rate increase that has been dangling since the summer of 2023 is 'quietly' making a comeback," he said. "It is, however, not surprising because several FOMC [Federal Open Market Committee] members," including Fed Chairman Jerome Powell, "have kept the option of a hike on the table."

Even before January's surprisingly hot CPI report landed a week ago, Jason Williams, a global market strategist at Citigroup (C), had openly discussed the possibility of Fed rate hikes in the context of a possible debate over the appropriate level of the neutral rate of interest, which neither stimulates nor restricts the economy. And as far back as a year ago, analysts at Credit Suisse had anticipated the possibility that the Fed's projected rate hikes at the time wouldn't be sufficient enough to tame inflation.

One immediate risk of a possible Fed rate hike to financial markets is that such a scenario isn't currently priced into the 10-year Treasury yield BX:TMUBMUSD10Y against "crowded" equity positions, according to Emons. Rising Treasury yields and higher-for-longer interest rates have a way of unnerving stock investors partly because the future cost of doing business also goes up. On Tuesday, the 10-year rate finished lower for the third time in the past four sessions. falling 1.8 basis points on the day to 4.276%.

The last time that the Fed's meeting minutes were released was on Jan. 3, when the record of the central bank's December gathering showed that officials hadn't yet ruled out further rate hikes. Nonetheless, investors and traders started pricing in as many as six or seven quarter-point rate cuts for this year, more than policymakers had indicated would be appropriate. See also: Does January jobs report put interest-rate hike on the table? Probably not - but watch this space, says economist

Now that expectations have settled around at least three quarter-point Fed rate cuts by December, many investors are looking for fresh clues about how policymakers are likely to react to the most recent round of inflation data. Minutes of the Fed's Jan. 30-31 meeting are scheduled to be released at 2 p.m. Eastern time on Wednesday.

"What we could learn is how scared they are about inflation settling above 2% and how worried they might be about it not falling far enough, which would then delay the first rate cut and might take some of the air out of risk assets," said economist Derek Tang of Monetary Policy Analytics in Washington.

"A lot of attention will be on Fed officials' reaction function and what could make them cut after March," Tang said via phone on Tuesday. "The bar for hiking is very high" so policymakers "are more likely to hold off on rate cuts or not cut at all for much longer than people think."

Financial markets returned from the three-day Presidents Day weekend in a risk-off mood on Tuesday, with all three major U.S. stock indexes DJIA SPX COMP closing lower. This week's marquee event is seen as Wednesday's release of earnings results from Nvidia Corp. (NVDA).

-Vivien Lou Chen

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02-20-24 1606ET

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