Market Pricing in Rate Hikes ≠ Fed About to Raise Rates? Wall Street: This Road Won't Be Easy...

Caixin March 25 News (Editor: Xiao Xiang) For the global financial markets, a major shift caused by the Middle East conflict this month is undoubtedly investors beginning to bet on the Federal Reserve’s next move being a rate hike. However, many industry insiders say that the ongoing weakness in the U.S. labor market and the surge in oil prices pose downside risks to economic growth, making it unlikely that the Fed will actually implement a rate hike…

Pricing in the interest rate futures market shows that on March 19, federal funds rate futures first priced in a 6% chance of a rate hike at the April FOMC meeting, and this has remained in positive territory since then. This marks the first time since December 2023 that investors have believed the likelihood of a rate hike at the next policy meeting exceeds that of a rate cut.

This shift among investors highlights the enormous uncertainty for the U.S. economy that could be brought about by the Iran-U.S. conflict and rising oil prices. But economists and analysts closely watching the Fed say that the probability of a rate hike in the short term remains very low…

Expecting a rate hike is one thing; actually implementing it is another?

Veronica Clark, an economist at Citigroup, said, “Of course, the oil shock is a new inflation risk, but if there are other impacts, they are also negative shocks to economic growth, and could even be bad for employment.”

Fed policymakers seem to share this view. In the first dot plot released after the Middle East conflict erupted, none of the 19 Fed officials forecast a rate hike this year, with only one predicting a hike in 2027. In fact, most officials still hint at the possibility of rate cuts again.

Federal Reserve Chair Jerome Powell told reporters at a press conference after last week’s policy meeting that the committee did discuss the possibility of a rate hike as the next step. But he added that, despite this, “the vast majority” of FOMC members still see rate hikes as not their baseline scenario.

Subsequently, Fed officials quickly pointed out that the impact of oil price shocks on inflation might be temporary, and that adjusting rates takes months to influence the economy. This means that the downward pressure on inflation from rate hikes may only become apparent after price increases end or even decline.

Many industry analysts also say that for a rate hike to be justified, the surge in energy prices must persist for a long time and affect other commodities and services, while also being accompanied by a labor market that pushes wages higher.

Although the memory of the high inflation shock triggered by the Russia-Ukraine conflict in 2022 may cause concern among investors, the economic backdrop then was very different from now. The Fed’s preferred inflation indicator had already risen above 6% early that year, and the unemployment rate had fully recovered from the pandemic. Under a tight labor market, companies competed fiercely to hire workers, further fueling inflationary pressures.

In contrast, by 2026, the U.S. labor market has been experiencing a prolonged period of weak hiring. Although there were signs of stabilization at the end of last year, officials unexpectedly saw a decline in non-farm payrolls in February.

Another reason to doubt the rate hike outlook is that once Trump’s nominee for the next Fed chair, Kevin Woehr, receives final Senate confirmation, the White House might pressure him to lower interest rates. An analysis by Bank of America’s Aditya Bhave noted that Woehr’s recent comments emphasizing the urgency of rate cuts make it hard to imagine him adopting a hawkish stance after taking over as chair.

So how should we view the rising rate hike expectations emerging in the current interest rate futures market? In this regard, TD Securities rate strategist Molly Brooks said some of these trades are less about predictions and more about “insurance” against unlikely but potentially destructive outcomes.

Brooks pointed out, “Before the initial attack on Iran, we were all looking at the fundamentals and leaning toward rate cuts. But once people saw the oil shock, concerns about inflation resurfaced.”

PIMCO prefers contrarian trading: buy bonds!

It’s worth noting that as Middle East tensions and global central bank policy expectations shift toward a hawkish stance, market volatility has intensified. Pacific Investment Management Company (PIMCO) is currently promoting “counter-cyclical investment opportunities.”

This month, the global bond market experienced its worst sell-off since October 2024, driven by rising oil prices due to the conflict and the risk of inflation returning, prompting traders to prepare for possible rate hikes in the UK, Europe, and the U.S. later this year. However, PIMCO recommends increasing holdings of interest rate-sensitive global bonds.

According to PIMCO economists Tiffany Wilding and Global Fixed Income Chief Investment Officer Andrew Balls, the energy shock has increased the likelihood of stagflation—where economic growth is sluggish, unemployment remains high, and inflation stays elevated.

They wrote in a report, “Central banks are unlikely to follow the recent market repricing of policy rates closely,” and that the impact will be more directly transmitted to vulnerable households, small businesses, and credit markets.

“In fact, the market’s instinctive reaction to tighter financial conditions and a more hawkish monetary policy has largely done the hawkish work for policymakers,” they said. If inflation continues to rise in the short term and the economy weakens, “central banks may need to adopt more aggressive easing measures.”

During the volatile trading this month, yields on U.S. 2-year to 10-year Treasuries once rose nearly 50 basis points, with short-term yields approaching 4%, and the 10-year yield hovering around 4.37%, close to the upper end of the past year’s main range of 4%-4.5%.

PIMCO also referenced a period of intense bond market volatility last year—when U.S. tariffs on trading partners exceeded expectations, causing a brief spike in Treasury yields. “Similar to the volatility after the U.S. announced tariffs in April 2025, the rapid repricing of central bank expectations in response to the Middle East conflict has caused localized fluctuations and created contrarian investment opportunities,” Wilding and Balls wrote.

PIMCO’s main investment recommendations for the next 6 to 12 months include:

Favor “moderate duration overweight,” increasing allocations to interest rate-sensitive global bonds—believing the U.S. Treasury market remains a recognized ‘safe haven’ source of returns and can provide diversification benefits, and “the case for global diversification remains strong,” as differences among countries become apparent, allowing active investors to profit;

Instead of trying to predict global market trends, benefit from risk exposures in specific developed and emerging markets with attractive real yields and credible policy frameworks;

For portfolios with increased equity exposure, view rising yields on high-quality bonds as a “practical opportunity to consider rebalancing”;

In private credit, signs of credit stress at the cycle’s end highlight the importance of selective targeting, cautious assessment of pricing and liquidity terms, and prioritizing high-quality collateral-backed investments;

Favor mortgage-backed securities (MBS), investment-grade issuers with stable and predictable cash flows, and high-quality securitized credit;

Exercise caution regarding “weakly covenanted direct loans and bank loans, lower-quality high-yield issuers, and many structured finance vehicles with liquidity and underlying asset mismatches.”