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Markets are now bracing for the possibility of bigger Fed interest rate hikes ahead

As inflation climbs to new 40-year highs, expectations for interest rate increases from the Federal Reserve are escalating as well. With the rate-setting Federal Open Market Committee scheduled to hold a policy meeting this week , markets are ramping up their bets on the way things will go, particularly in the months ahead. There’s still about a 2-to1 chance that this week’s meeting, which concludes Wednesday, will see a 50 basis point increase, according to the CME Group’s FedWatch tool that measures pricing in the fed funds futures markets. But the potential for a 75-basis-point move is rising, up to 34% Monday morning compared to just 3.1% a week ago. That big move came following Friday’s consumer price index report showing that inflation in May jumped by 8.6% from a year ago, the biggest 12-month gain since December 1981. Markets now see a greater chance of the Fed moving more aggressively, if not now then in coming months. FedWatch is indicating that the central bank’s benchmark interest rate will now end 2022 in a range of 3.25%-3.5% from its current 0.75%-1% target. There’s even about a 44% chance of going a quarter-point above that, according to pricing around noon ET Monday. “US Treasury curve is now pricing in ten Fed rate hikes of 25 bp by year end,” Jeffrey Gundlach, DoubleLine Capital CEO, tweeted late Sunday . “There are five Fed meetings before year end (starting with this week). The bloodless verdict of the market is a 50 bp hike every meeting unless [Fed Chairman Jerome Powell ] puts bigger individual hikes ‘on the table’ before that.” A slew of big hikes ahead If the Fed proceeds on that path, it would represent the most significant tightening since the 2004-2006 cycle, when then-Chairman Alan Greenspan was trying to slow an economy in the midst of a real estate bubble that ultimately would pop in 2007. While traders are looking for a 50 basis point move this week, they’ve upped the chances considerably for a 75 basis point increase in July, now putting that probability at 71%. The market then is pricing in 50 basis points in September, 50 more in November, then 25 in December. Investors will get a better look at Fed officials’ expectations Wednesday when the central bank releases its revised “dot plot ” of individual members’ outlooks. “Fed officials who very recently were expressing hopefulness that inflation would slow over the course of the year will now have to confront a backdrop of prices that are accelerating despite the rapid tightening of financial conditions,” Citigroup economist Andrew Hollenhorst said in a note. “This should mean rising median ‘dots’ and inflation forecasts along with the potential to consider larger sized 75bp rate increases.” “With this already priced-in by markets, the most important take away may be whether Chair [Jerome] Powell maintains his resolve to tighten financial conditions and slow inflation, even if the required tightening is increasingly likely to lead to a recession rather than a ‘softish’ landing,” he added. The market has done some of the Fed’s work Stocks and bonds have been in tumult as the inflation readings have soared. Markets worry that if price expectations become unmoored, it will lead to even greater Fed tightening and an end to the easy-money policies that have helped propel the market since the darkest days of the financial crisis in 2008. “There is a tremendous amount of tightening in financial conditions,” said Joseph LaVorgna, a Wall Street veteran and chief economist for the National Economic Council under former President Donald Trump. “The housing market is shutting down, the equity market is imploding, credit spreads are widening and the dollar is strengthening.” “Inflation is lagging indicator,” he continued. “If I was the Fed I would be talking about the fact the economy is fundamentally weak, the Fed is very conscious of inflation. There is tremendous demand destruction coming from this significant tightening in financial conditions.” But LaVorgna expects the Fed, and particularly Powell at his post-meeting news conference, to respond to market pricing and continue to raise rates aggressively. “The Fed needs to talk less about what it’s going to do and [talk] more about how tightening in financial conditions is going to do a lot of its job for it,” he said. “That’s what the Fed should to. To me, the Fed is going to make a classic policy mistake by setting monetary policy looking in the rearview mirror.” Financial conditions as judged by a Chicago Fed gauge are at their tightest levels since May 2020, in the early days of the Covid pandemic. The Fed is hoping to use its rate hikes plus a balance sheet reduction to tighten conditions and slow the economy. Officials have said, though, that there is still work to be done before that goal is achieved. “I would do a whole do-over on all the Fed has done the last 15 years, but they can’t do that,” LaVorgna said. “They’re stuck going down this path of transparency. It’s a mess.”

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