Citadel Securities indicates that investors are currently underestimating the possibility of the Federal Reserve raising interest rates as early as this month, as Chairman Kevin Warsh appears poised to adopt a more preemptive strategy to combat inflation.
The firm's Head of Macro Strategy, Frank Flight, continues to view two rate hikes this year—one in September and another in December—as the base case scenario. Even so, he notes that the market is currently pricing in only about a 30% probability of a July hike, a level he considers too low.
Flight wrote in a client note that investors remain anchored to the view that the Fed will only tighten policy after economic data overwhelmingly demonstrates the necessity for action. However, Flight believes Warsh is adopting what Citadel terms an "adaptive" framework, under which the central bank would act early to prevent inflationary pressures from becoming entrenched.
Speaking at a forum on Wednesday, Warsh reiterated his commitment to bringing inflation back to the Fed's 2% target, while also acknowledging that inflationary risks have moderated somewhat in recent weeks.
Prior to Warsh chairing his first policy meeting last month, Flight had warned that the new Fed chair could surprise investors by taking a more hawkish stance, a call that later proved prescient. During that meeting, Warsh pledged to restore price stability, while Fed officials signaled stronger support for rate hikes this year as inflation accelerated to its highest level since 2023.
Flight wrote that market performance following the June policy meeting, including a stronger U.S. dollar, a flattening Treasury yield curve, and resilient risk assets, suggests investors are able to digest a "series of short, sharp, credibility-enhancing hikes."
He added, "Missing the first 'walk the talk' opportunity could make Chairman Warsh's June press conference look like a show and may cause the market to give back some of the newly gained credibility premium."
The strategist also sees a risk that the June employment report, due Thursday, could exceed expectations, suggesting consensus estimates may be underestimating hiring related to the FIFA World Cup. He pointed out that the threshold for the unemployment rate to fall from 4.296% to 4.20% is relatively low.
Against this backdrop, Flight stated that the U.S. Treasury market is becoming more vulnerable as investor positioning becomes less favorable. Citadel's flow analysis now shows net selling is on the rise, following a period of substantial buying that helped push yields lower in late May.
He wrote, "Taken together, these signals could imply that yields have upside risk from current levels."
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