Traders are upping their bets that US interest rates will be higher for longer after Australia and Canada’s central banks unexpectedly lifted borrowing costs to combat inflation and the US labour market proved stronger than expected.
Pricing in the Treasury futures market now firmly points to a quarter-point interest rate rise by the US Federal Reserve in July after a pause in June, while expectations of rate cuts for later this year have fallen, according to Refinitiv data.
Strong US economic data in recent weeks, including a robust jobs report, have fuelled these bets, which traders added to after the decisions in Canada and Australia.
Citing recent data suggesting increasing “upside risks” to higher inflation, the Reserve Bank of Australia on Tuesday defied consensus forecasts by increasing its cash rate target by 0.25 percentage points to 4.1 per cent, the highest level since 2012.
The Bank of Canada followed suit on Wednesday, lifting rates for the first time since January from 4.5 per cent to 4.75 per cent on the back of strong first-quarter gross domestic product numbers — surprising investors who had thought it would leave rates unchanged.
Consumer prices in Canada rose for the first time in 10 months in April and “concerns have increased” that inflation could remain “materially” above 2 per cent, the bank said.
The BoC’s decision to restart its tightening pushed local 10-year government bond yields to their highest level since April and sparked a sell-off in US Treasuries across a range of maturities. It also served as a “warning signal” to central banks, such as the Fed, that had been contemplating a pause, said Elwin de Groot, head of macro strategy at Rabobank. Yields rise as prices fall.
Concerned that further tightening in June might exacerbate a potential credit crunch triggered by the collapse of several regional banks in March, some rate-setters on the Federal Open Market Committee have in recent weeks suggested the central bank might lift interest rates in July after pausing its aggressive tightening cycle when it meets next week.
Fed governor Christopher Waller, a voting member on the committee, said late last month that he did not support stopping rate rises, even if “prudent risk management” suggested pausing in June but raising rates again in July.
Markets still expect that a 25 basis point increase in July will be the last of the current cycle. But some investors who had previously thought the Fed would lower rates significantly later this year have recently backed out of those bets, with roughly 0.8 percentage points of expected cuts by the end of the year having been removed from market pricing since the start of May.
The BoC’s decision on Wednesday briefly pushed the probability of a July rate rise by the Fed from 80 per cent to 90 per cent, according to analysts at ING.
“Investors are starting to see a pattern emerging”, with this week’s moves running “against the prevailing narrative that central banks are on the verge of pausing their rate hikes”, said Jim Reid, an analyst at Deutsche Bank.
The Fed faces many of the same issues troubling central bankers in Canada and Australia. The US labour market remains tight and although headline inflation has been on a downward trajectory since June 2022, core inflation, which strips out volatile food and energy prices, has barely budged since the end of last year.
The BoC had forced the market to “reconsider what the Fed might do, not necessarily next week, but further out”, said Mike Zigmont, head of trading and research at Harvest Volatility Management. “Maybe Fed easing later in the year isn’t as likely as everyone thinks.”
