Middle East conflicts ignite inflation triggers! Has the Federal Reserve's "zero rate cut" become the top script of the year?

Cailian Press, March 6 (Editor: Xiaoxiang)
Latest signs show that bond options traders are increasingly betting that the Federal Reserve will abandon rate cuts this year, as escalating conflicts in the Middle East have significantly pushed up oil prices and may boost inflation.

Data from the Atlanta Fed indicates that as of Wednesday, traders are pricing in a 25% chance that the Fed will keep the benchmark interest rate unchanged until the end of this year, up from 17% on the last trading day before the US-Iran conflict erupted (last Friday).

Notably, among all potential scenarios, the probability of holding rates steady has now risen to the highest.

According to the Atlanta Fed data, other interest rate scenarios include: a 24% chance of one rate cut (25 basis points) this year, and a 12% chance of two cuts. Traders even believe the chance of a rate hike has reached 16%, up from 8% last Friday.

This data is based on SOFR futures options linked to the Federal Reserve’s policy rate.

“When oil prices surge, we must consider their impact on inflation,” said Dan Carter, senior portfolio manager at Fort Washington Investment Advisors. “This will push up inflation levels and reduce the likelihood of the Fed cutting rates.”

Of course, considering all possible scenarios, the overall market expectation still leans toward rate cuts. But pricing changes indicate that, with crude oil prices rising nearly 20% this week, traders’ confidence in the Fed lowering borrowing costs has significantly weakened.

In recent days, options market flows have continued to show a prudent demand to hedge against the risk of the Fed’s easing policy weakening.

The interest rate swap market—another tool for betting on Fed policy—also reflects market expectations that the Fed’s stance will tighten. Currently, traders are pricing in about a 35 basis point cut by the end of the year, down from an expectation of around 60 basis points last weekend.

Meanwhile, the cooling of rate cut expectations has already triggered a sell-off in US Treasuries this week, pushing yields to multi-week highs. Data shows that yields across various maturities rose again on Thursday, with the 2-year Treasury yield up 3.72 basis points at 3.578%, the 5-year yield up 5.05 basis points at 3.727%, the 10-year yield up 4.04 basis points at 4.136%, and the 30-year yield up 1.87 basis points at 4.754%.

Michael Green, Chief Market Strategist at Simplify Asset Management, said that the surge in gasoline prices caused by Middle East tensions clearly worries those expecting the Fed to take action. The real key is that inflation concerns are weakening market expectations of rate cuts, which is the main force driving changes in the yield curve.