June Fed rate-hike risk looms as U.S. labor market stays strong

By Vivien Lou Chen

Traders have hesitated to fully price in a path of higher U.S. interest rates, preferring instead to stick with a greater likelihood of no action by the Federal Reserve until possibly September

The once-unthinkable scenario of no interest-rate cuts by the Federal Reserve in 2024 is now giving way to another possibility: a slight chance of a quarter-point rate hike by June.This latest scenario can be seen in the market-probability tracker of the Fed's regional bank in Atlanta, where options on the Secured Overnight Financing Rate traded at levels that implied a roughly 3.6% chance of a quarter-point hike for June, as of this week. Such action would lift the fed-funds rate target to between 5.5% and 5.75%, from a current level of 5.25% to 5.5%.

Rate-hike scenarios have been contemplated by options traders for months. They also briefly showed up in fed-funds futures on Thursday after weekly initial jobless-benefit claims came in unchanged in a sign of no rising layoffs, and after a Philadelphia-area factory gauge reflected improving conditions. However, traders have hesitated to fully price in a path of higher U.S. interest rates, preferring instead to stick with a greater likelihood of no action by the Fed until possibly September. "We are seeing more discussion among a lot of clients about rate hikes," with more of them now in the "one-or-none camp" when it comes to 2024 rate cuts, said Scott Buchta, the Tennessee-based head of fixed-income strategy for Brean Capital. The bar for a Fed rate hike is likely to be high, according to the strategist. He added that his firm is putting a 60% likelihood on a scenario in which the U.S. economy can keep growing, inflation manages to moderate, and policymakers can deliver two rate cuts this year followed by three more cuts in 2025. Meanwhile, people are starting to move toward an "inertia trade" in which inflation stays sticky, the economy holds up, and the "Fed doesn't do anything" - producing greater interest in shorter-duration, floating-rate assets, the strategist said.Speculation about the possible need for higher borrowing costs gained momentum on Thursday after the question was posed directly to a prominent Fed official. Speaking at an event in Washington, New York Fed President John Williams failed to rule out the possibility that the central bank's next move might be to raise rates, though that isn't his base case. Williams said that if the data indicates a need for higher interest rates to achieve the Fed's goals, then policymakers would "obviously" want to do that."Williams didn't push back" on the rate-hike question, said economist Derek Tang of Monetary Policy Analytics in Washington. The policy-setting Federal Open Market Committee still "has a lot of room to take out rate-cut expectations, and that would tighten financial conditions," Tang said via phone. "I think they are nervous about hiking again and the hope is that they can keep recession risks under control. But they're cutting it really close, and there is not as much room for error as there was a few months ago." On Thursday, the rate on the 1-year inflation swap, a market-based measure of expected inflation, was at 2.72% - up from just below 2% in January and yet far from the roughly 6% levels seen during 2022, according to Bloomberg data. Treasurys sold off, pushing the policy-sensitive 2-year rate BX:TMUBMUSD02Y to almost 5%, as U.S. stocks indexes DJIA SPX COMP finished mostly lower.Conversations at the moment are centered on "what higher for longer means, and that starts to matter for the valuation of risk assets," said Robert Daly, who manages more than $4.5 billion in assets as director of fixed income at Glenmede Investment Management in Philadelphia. "Talk of hiking is still small, but could come to a fever pitch if we do not see an immaculate disinflation scenario play out," Daly said via phone on Thursday.

-Vivien Lou Chen

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04-18-24 1609ET

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