EJFQ Analysis | "Interest Rate Crystal Ball" Preview: The US is approaching a rate hike critical point

Since the United States and Israel launched attacks on Iran, oil prices have fluctuated significantly with the news of the war, while the stock market moved in the opposite direction. Brent crude futures on Monday (23rd) once plunged 14.4%, closing slightly below $100. The S&P 500 index surged back, ending at 6,581 points, up 1.15%, but the 200-day moving average—considered the “bull-bear dividing line”—was regained and then lost again. Since the short-term market breadth only increased from 12.9% last Friday to 16%, about 84% of stocks remain constrained by the 20-day moving average, suggesting that the oversold rebound in the index may not be over yet.

The bond market released even more important signals on the same day. The yield on the two-year U.S. Treasury surged to 4.0116%, the first time breaking above 4% in over nine months. Although it later retreated to 3.8519%, it has remained above the Federal Funds Rate target upper limit of 3.75% for four consecutive trading days.

The rise in the two-year Treasury yield, which is highly sensitive to interest rate expectations, was mainly driven by Fed Chair Powell’s unexpected mention last week that internal discussions had considered “not cutting rates but raising them,” amid high oil prices fueling inflation and pushing short-term yields above official policy guidance. Historical data shows that in 2022, short-term yields also “overtook” the Fed Funds Rate target upper limit, prompting the Fed to adopt a “hawkish tightening” stance, raising rates by a total of 4.25%. Similar situations occurred during previous tightening cycles in 2015 and 2004.

At the end of last year, most analysts estimated that the easing cycle would not end until 2026, with no consensus on the magnitude of rate cuts. However, due to the uncertainty surrounding the Middle East war, investor sentiment has reversed, leading to bond market responses and futures markets reflecting a simultaneous bet on rate hikes. The Federal Funds Rate futures, a core tool for predicting U.S. interest rate movements, are used by traders, hedge funds, and banks to place real-money bets on rate trends. Their accuracy in predicting monetary policy is often considered higher than the Fed’s dot plot, earning them the nickname “interest rate crystal ball.”

As shown in the accompanying chart, since Donald Trump was elected U.S. President in early November 2024, he has continuously pressured the Fed to cut rates. Based on the implied interest rate derived from the December 2026 Fed Funds futures contract, the rate has repeatedly fallen from nearly 4% to 2.5%. Even after the Fed slowed its tightening amid a weakening labor market last September, rate cut expectations further cooled. However, after the outbreak of Middle East conflict on February 28 this year, futures markets sharply increased their rate forecasts from around 3%, indicating that the expectation of two or three rate cuts before the end of 2026 has essentially disappeared. Additionally, the latest implied rate on this contract has approached the critical 3.75% level for several days. A break above this level would mark a major turning point after the end of the 2023 rate-hiking cycle.

In other words, based on bond and futures market trends, U.S. monetary policy is approaching a “tightening from easing” critical point. The longer the Middle East conflict persists, the greater the inflationary pressure from rising oil prices, and the sooner the Fed may raise interest rates. This could lead to another reshuffling of global asset prices, especially as the bullish logic behind the current U.S. stock rally may be thoroughly reversed.

HSBC Investment Research Department

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