Federal Reserve to "Emergency Rate Hike" Within Two Weeks? Traders Start Hedging Against the Most Extreme Middle East Conflict Risks

There are signs that, against the backdrop of the U.S. continuing to increase troop deployments to the Middle East and oil prices staying high, bond traders are becoming increasingly uneasy about the outlook for a further escalation of the situation in Iran. Some traders are trying to hedge the war’s aftereffects under a “worst-case scenario”—a situation that could force the Federal Reserve to raise interest rates within the next few weeks.

In the interest-rate options market tracking Fed policy, this week saw rising demand for bets related to secured overnight financing rate (SOFR), and these bets align with expectations for an “emergency rate hike” within the next two weeks at the fastest. In other words, if the bond market significantly revises upward its expectations for rate hikes before the Fed’s next policy meeting on April 29, these positions are set to be profitable.

The rapid surge in hedging demand for the emergency rate-hike scenario also marks a sharp reversal in market sentiment:

Just a month ago, market participants still expected the Federal Reserve could deliver three 25-basis-point rate cuts by the end of this year. But since the Feb. 28 start of the U.S.-Iran conflict, swap market traders have priced the probability of a rate hike before December at about 50%, which exposes short-term U.S. Treasuries to the risk of further repricing.

Of course, it needs to be noted that, for now, the interest-rate swap market is only pricing a 3-basis-point rate hike for the Fed’s April policy meeting—that is, the probability of a 25-basis-point rate hike is about 12%.

Jeff Schuh, head of rates trading at Constitution Capital, said that although the latest bets in the options market do not reflect the market’s commonly accepted baseline scenario, this nevertheless shows that the market is increasingly worried about the rapid rise in inflation, which would put investors taking long positions in U.S. Treasuries over the past few months at risk.

As worries that inflation is making a comeback have been driven by soaring oil prices, traders have recently closed out large amounts of long positions in U.S. interest-rate futures. Schuh said that the selling of SOFR futures and the broad-based rise across all maturities on the Treasury yield curve are leaving big funds off guard.

Schuh described the latest hedging trades above as a low-cost risk-management tool, saying they “make the risk of liquidation look more controllable in 90% of cases, and for funds seeking to manage interest-rate risk, this is an inexpensive remedy.”

The above hedging demand for an emergency rate hike is also clearly being driven by conflicting signals released by the United States and Iran regarding negotiations to end hostilities.

On Thursday, Iran said it rejected a U.S. ceasefire plan and proposed its own conditions. And although U.S. President Trump postponed the planned strikes on Iran’s energy facilities by 10 days, according to U.S. Department of Defense officials, the Pentagon is considering deploying ground forces of up to 10,000 troops to the Middle East.

This has left traders facing unprecedented uncertainty when it comes to the Fed’s policy outlook.

Chicago Fed President Goolsbee said earlier this month in an interview that, given the impact of oil prices on the U.S. economy, the Federal Reserve may need to tighten monetary policy.

BofA Securities analysts also recently pointed out that even if a ceasefire occurs in a future U.S.-Iran war, if energy prices cannot quickly fall back to pre-war levels and WTI crude continues to stay above $80 per barrel, the Federal Reserve may still adopt a policy that is more inclined toward rate hikes.

（Source: 财联社）