As inflation accelerates due to the Iran war, financial markets are increasingly betting that the U.S. Federal Reserve will raise interest rates at its next move.
According to the CME FedWatch tool as of 11 a.m. on the 23rd, the fed funds futures market is pricing in a roughly 35% probability that the Fed will hike rates by at least 0.25 percentage point by October.
That marks a dramatic reversal from a month ago, when 91.1% of market participants predicted rates would be lower by the October Federal Open Market Committee meeting. The probability of a rate cut has now collapsed to just 6%, effectively vanishing.
The market's view diverges from that of Fed officials. Although Fed Chair Jerome Powell acknowledged that "the Iran war will push inflation higher," Fed governors generally still expect an average rate cut of 0.25 percentage point this year.
However, policy-sensitive Treasury yields have surged sharply, reflecting the market's shifting expectations. According to the Financial Times, the two-year U.S. Treasury yield on the 20th rose as much as 0.11 percentage point intraday to 3.94%, approaching a one-year high. It closed at 3.88%, up 0.05 percentage point from the previous session and 0.5 percentage point higher since the war broke out. Yields move inversely to prices.
Concerns are deepening that persistently high oil prices could become a chronic problem as the Iran war, initially expected to be a short conflict with only temporary market impact, drags on. High oil prices translate directly into rising consumer prices. Market expectations for U.S. inflation over the next year have climbed more than 1 percentage point since the start of the year.
"Investor sentiment toward the Fed is shifting. Investors expect the war to last much longer," said Subadra Rajappa, head of U.S. research at Société Générale. "The assumption that the U.S., as an energy-independent nation, would absorb the shock relatively quickly is now being questioned."
Major central banks are accordingly taking a cautious approach to policy decisions. The Fed held its benchmark rate steady at 3.50%–3.75% on the 18th, citing Middle East war uncertainty. The Bank of England and the European Central Bank also opted to hold rates unchanged the following day.
