After unexpected rate increases in Canada and Australia, and strong US job data, the hopes of rate reductions later this year are fading. 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.
According to Refinitiv, the pricing of Treasury futures now clearly points to an rate increase by the US Federal Reserve after a pause during June. Meanwhile, expectations for rate cuts later this year are down.
These bets were fueled by the strong US economic data of recent weeks. This included a robust job report. Traders added to these bets after the decisions made in Canada and Australia.
The Reserve Bank of Australia, citing recent data that showed an increase in “upside risks” of higher inflation, defied the consensus forecasts on Tuesday by raising its cash rate target to 4.1 percent, the highest since 2012.
The Bank of Canada reacted in the same way on Wednesday. It raised rates from 4.5 to 4.75 percent for the first since January, citing strong gross domestic product figures from the first quarter. This surprised investors who thought that the Bank would keep rates the same.
The Bank of Canada said that consumer prices rose in Canada for the first 10 months. “Concerns have grown” about inflation remaining “materially” over 2 percent, it added.
The BoC decision to resume its tightening has pushed the yields on local 10-year government bonds to their highest levels since April. It also sparked an US Treasuries sell-off across a variety of maturities. Elwin de Groot of Rabobank, the head of macro-strategy, explained that it also served as an “alert signal” for central banks such as Fed who were contemplating a break. As prices drop, yields increase.
Some rate-setters at the Federal Open Market Committee, concerned that further tightening could exacerbate the credit crunch caused by the collapse of regional banks in march, have suggested in recent weeks that the central bank may raise interest rates in July if it stops its aggressive tightening when they meet next week.
Fed governor Christopher Waller is a member of the committee and voted on it. He said last month that even though “prudent risks management” recommended pausing rate increases in June, but increasing them again in July, he still did not support this.
The markets still believe that the 25 basis-point increase in July is the last for this cycle. Investors who thought that the Fed would reduce rates by a significant amount later this year, have recently changed their minds. The market has removed 0.8 percentage points from the expected reductions at the end of this year.
Analysts at ING say that the BoC’s Wednesday decision pushed up the probability of a Fed rate hike in July from 80 to 90 percent.
Jim Reid, a Deutsche Bank analyst, said that investors are beginning to notice a pattern. This week’s actions “run counter to the dominant narrative” that central banks were on the brink of halting their rate increases.
The Fed is facing many of the issues that are troubling central banks in Canada and Australia. The US labour markets remain tight. Although headline inflation has been trending downward since June 2022; core inflation, which excludes volatile food and fuel prices, has barely moved since the end last year.
Mike Zigmont is the head of trading at Harvest Volatility Management. He said that the BoC forced the market “to reconsider what the Fed may do in the future, not necessarily the next week but further away”. “Maybe Fed ease later in the year won’t be as likely as people think.”