Market Implies 30% Chance of Fed Rate Hike Next Week as Oil Prices Surge and Forward Guidance Remains Unclear

Rising oil prices combined with a lack of clear forward guidance from the Federal Reserve are causing markets to reassess policy risks.

Despite a consensus among mainstream economists that the Fed will hold steady next week, interest rate markets now imply a roughly 30% probability of a rate hike. This has pushed U.S. Treasury yields higher across the board. The two-year yield has hit its highest level since early 2025, the 10-year yield has climbed to a year-to-date peak, and the 30-year yield is nearing its highest point since 2007.

A July 23 research report from Citigroup argues that this market pricing does not signify widespread bets on an imminent Fed rate hike. Instead, it reflects investors demanding a higher risk premium to guard against policy surprises, amid increasingly vague forward guidance and the risk of inflation being fueled by higher oil prices.

Treasury Yields Surge as Market Priced for a 30% Chance of a Hike

Recently, escalating tensions in the Middle East have driven a sustained increase in international oil prices, rekindling market fears of a resurgence in inflation and pushing U.S. Treasury yields steadily higher.

On Thursday, the policy-sensitive two-year Treasury yield rose to around 4.365%. The benchmark 10-year yield simultaneously hit a new high for the year, while the 30-year yield climbed to 5.19%, just a step away from levels not seen since 2007.

Simultaneously, interest rate futures show that the market has implied a roughly 30% probability of a rate hike at the Fed's upcoming meeting. However, this pricing diverges significantly from the mainstream expectation. A Bloomberg survey of 70 economists found that none predict the Fed will raise rates next week.

Citigroup: The 30% Figure is Not a Forecast, but a Risk Premium

Citigroup offers a different explanation for this seemingly contradictory situation.

Economists Andrew Hollenhorst, Veronica Clark, and Gisela Young from Citigroup point out that the 30% implied in market pricing does not represent investors genuinely believing there is a 30% chance of a rate hike. Instead, it includes an additional risk premium.

The report argues that since a rate cut is virtually impossible at the next meeting, the policy risk is naturally one-sided. In the event of an unexpected rate hike, the bond market would be far more severely impacted than if the Fed holds steady. Therefore, investors are willing to pay an extra cost to price in this tail risk in advance.

Historically, the risk premium associated with a Fed meeting has typically been just 1 to 2 basis points, according to Citigroup. However, as the Fed has reduced its forward guidance and its policy communication has become more data-dependent in recent years, uncertainty has increased, and the risk compensation demanded by the market has correspondingly expanded.

This logic also explains the current movement in long-term yields. Citigroup believes that if a future meeting were to result in an unexpected rate hike, the market would likely view it as the start of a new tightening cycle, rather than an isolated event. Consequently, expectations for the terminal rate would also rise. This is why the market currently prices in cumulative rate hikes of over 50 basis points by next March, but this does not mean it is the investors' baseline scenario.

Citigroup: The More Unclear the Forward Guidance, the Easier Rates Stay High

Citigroup suggests that the recent rise in oil prices is merely a catalyst prompting the market to reassess the policy path. The deeper reason lies in the change in the Fed's communication framework.

The report notes that the Middle East situation has pushed up oil and U.S. gasoline prices, reinforcing market concerns about a resurgence in inflation risk. In the absence of clear policy guidance from Fed officials, this uncertainty further amplifies market worries about potential policy surprises.

Citigroup emphasizes that during periods of clear forward guidance, market risk premiums are typically negligible. However, currently, each FOMC meeting carries greater policy uncertainty, forcing investors to pay a risk premium in advance for potential surprises.

This means that even if the Fed ultimately holds rates steady, Treasury yields may not decline significantly simply because the expectation of a rate hike fades. Citigroup believes that until the Fed re-establishes a clearer communication framework, the phenomenon of yields being driven higher by risk premiums is likely to persist.