Federal Reserve policy "changes overnight"? Wall Street begins to discuss: What if interest rates are raised this year?

Recently, investors have begun to ponder an "awkward" question: how will the Federal Reserve "justify" itself if it has to raise interest rates this year?

Although CME Group's FedWatch shows that the probability of a rate hike is nearly zero, as economic conditions change, investors are starting to reassess: Will the Federal Reserve acknowledge that last year's series of aggressive rate cuts were a mistake and possibly reverse its policy in the short term?

The Federal Reserve's decisions are not solely dependent on the "heat" of the economy or whether the new Trump administration's tariffs, immigration, and tax policies will lead to inflation. James Mackintosh, a columnist for The Wall Street Journal, pointed out on the 14th that the core question for investors is: Is the barrier to raising rates greater than the barrier to cutting rates?

In the face of rising inflation, Wall Street expects tonight's CPI data to return to the 3% range for the first time in five months. Although the likelihood of a rate hike in the short term is low, if the Federal Reserve truly begins to discuss raising rates, the market may react significantly even before an actual rate hike occurs.

Will the Federal Reserve's policy change overnight?

Mackintosh stated, the Federal Reserve typically signals major policy changes in advance and thoroughly verifies before deciding to raise rates. Since it began issuing post-meeting policy statements in 1994, the Federal Reserve has only transitioned from rate cuts to rate hikes in a short year in 1998.

At that time, the collapse of Long-Term Capital Management threatened Wall Street, prompting the Federal Reserve to quickly lower interest rates, but it did not begin raising rates until seven months later, after confirming economic stability.

Some analysts believe that the Federal Reserve did not respond quickly enough to the inflation shock of 2021-2022, and therefore may act swiftly in the face of recovery threats.

Ed Al-Hussainy, a global interest rate strategist at Columbia Threadneedle Investments, stated:

"They will not hint at a rate hike before obtaining more data. But if the data becomes overwhelming, they will quickly break through that psychological barrier."

Mackintosh suggested that investors who believe the barrier to raising rates is greater might consider purchasing short-term government bonds, such as one- or two-year bonds. This could achieve a win-win situation:

"If the economy is doing well, the Federal Reserve will maintain low rates, and investors will earn returns; if the economy worsens, the Federal Reserve may cut rates, leading to an increase in bond prices."

However, this strategy also carries risks. Mackintosh pointed out that the biggest risk is if the Federal Reserve actually raises rates, causing bond prices to fall. A more subtle and likely scenario is that the Federal Reserve remains inactive, but traders begin to prepare for a rate hike by selling government bonds, similar to what has recently occurred in the long-term bond market

Interest Rate Hike Expectations Stirring

In the past eight months, the 2-year U.S. Treasury yield has fallen from 5% to 3.5%, currently hovering around 4.3%.

Currently, signs of interest rate hikes are reflected in the options for the Secured Overnight Financing Rate (SOFR). The Atlanta Federal Reserve noted that SOFR options before the end of the year indicate a 35% probability of a rate hike, which is a 5 percentage point increase since the Federal Reserve's rate cut last December. However, a rate hike is still far from the market's general expectation.

Gregory Peters, Co-Chief Investment Officer of PGIM Fixed Income, stated that the market has somewhat priced in this asymmetry, but volatility is high.

"I think the consensus is that the divergence (between rate cuts and hikes) is favorable for investors. But we are experiencing a very broad range."

Amid rising inflation concerns and ongoing uncertainty regarding the Federal Reserve's actions, the U.S. fear index VIX has risen to nearly 20, indicating strong market anxiety