Global central banks reprice hawkish stance: Is the market overestimating rate hikes?

Since the escalation of the Middle East conflict at the end of February, an epic energy shock has swept across the globe. Disruptions to shipping in the Strait of Hormuz and attacks on energy facilities in the Persian Gulf have severely damaged energy supplies, causing a surge in oil and gas prices and a rapid rebound in global inflation expectations. In response, the policy expectations of major central banks around the world have undergone a dramatic and violent restructuring.

Just a month ago, the market was pricing in 2-3 rate cuts by the Federal Reserve within the year; however, as inflation concerns rapidly escalated due to the energy shock, the market quickly shifted to price in the tail risk of rate hikes, even emergency rate hikes. The OIS market has priced the probability of a rate hike by the Federal Reserve before December this year at around 50%; meanwhile, there has been a surge in trading demand linked to SOFR that bets on a rate hike by the Federal Reserve within two weeks.

The global bond market has also faced severe sell-offs, with U.S. Treasury yields rising significantly across all maturities, displaying marked characteristics of bear flattening in the yield curve. The sharp pivot in interest rate pricing reflects the market’s repricing of re-inflation risks, which has created systemic shocks to asset prices: the bond market has undergone substantial adjustments, while stocks and credit assets are under pressure, and cross-asset correlations have risen significantly.

More importantly, financial conditions have tightened significantly even before the Federal Reserve has taken action. The rapid rise in short-term rates has directly pushed up financing costs, and combined with the yield curve adjustment, has created preemptive constraints on corporate investment and consumer spending. This means that even if the Federal Reserve maintains rates, the market itself is already substituting rate hikes.

Meanwhile, there is a significant divergence between market expectations and the guidance and statements from the Federal Reserve. On one hand, traders are aggressively pricing in rate hike risks in the interest rate market; on the other hand, the Federal Reserve’s guidance and officials still tend to favor “maintaining rates unchanged for a longer time,” and even keep the possibility of rate cuts later this year. This expectation divergence itself reflects the high levels of sentiment and tail risk premium embedded in the current pricing.