Interest rate swap market data indicates that traders now estimate the probability of the Federal Reserve raising interest rates before the end of 2026 has exceeded 80%, a sharp surge from 30% a month ago, marking a fundamental reversal in market expectations for the monetary policy path.
Rate Hike Expectations Shift from Fringe to Mainstream Swap market pricing shows that the market has fully priced in expectations for a 25-basis-point rate hike at the Fed's policy meeting next April. The speed of this shift has caught market participants off guard. As recently as February this year, traders widely anticipated two to three rate cuts within the year. Now, not only have rate cut expectations completely dissipated, but a rate hike has evolved from a tail risk to the baseline scenario.
Longer-term Treasury yields are also rising in tandem. The 30-year U.S. Treasury yield is currently hovering around 5%, having previously broken through this key psychological level for the first time this year. The 2-year Treasury yield is approximately 3.88%, above the current federal funds rate range of 3.50% to 3.75%, indicating that bond market investors are also preparing for a rate hike.
Stubborn Inflation is the Core Driver The core variable prompting the market's repricing is inflation. April CPI data showed that U.S. inflation accelerated, driven by rising energy prices, with core inflation still as high as 3.3% year-over-year, far above the Fed's 2% target. Ongoing conflict in Iran continues to push oil prices higher, with Brent crude maintaining around $110 per barrel, suggesting inflationary pressures will be difficult to alleviate in the short term.
Significant divisions have emerged within the Federal Reserve. Cleveland Fed President Harker, Minneapolis Fed President Kashkari, and Dallas Fed President Logan have all publicly stated that the Fed should clearly signal that the next policy move is more likely to be a rate hike than a cut. At the April FOMC meeting, four members dissented, marking the largest disagreement in over 30 years.
Analysts: The Bar for a Rate Hike Remains High Despite the market's sharp shift, some strategists are cautious about an actual rate hike. Lawrence Gillum, Chief Fixed Income Strategist at LPL Financial, stated, "The bar for a rate hike is still much higher than the bar for holding rates steady." He believes the duration of the Iran conflict will be a key variable; a prolonged conflict would further increase the probability of a hike, but the window for a rate cut is not yet completely closed.
The market will closely watch the Federal Reserve meeting minutes scheduled for release on May 20th for more clues about the policy path. The imminent formal succession of Kevin Warsh as Fed Chair and his policy orientation have also become a focus of market attention.
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