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(Bloomberg) -- Money markets now see the Federal Reserve’s key overnight rate peaking at 4% by the middle of next year, as expectations for policy tightening ramp up.
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Pricing for the US central bank’s so-called terminal rate comes as traders bet on nearly 200 basis points of rate increases at the next three Fed rate decisions, with a 50% chance of a three-quarter point hike coming as soon as this week.
“Fed credibility is the lynchpin,” said George Goncalves, head of US macro strategy at MUFG. “They cannot waver, they cannot be dovish until there is evidence of slowing inflation. They are only at 1% and need to get above 3%.”
The aggressive recalibration was accompanied by a 30-basis-point surge higher in Treasury benchmarks that are the most sensitive to policy changes. Selling pressure intensified late on Monday, in the wake of a Wall Street Journal report flagging the prospect of a surprise three-quarter point hike this week. The Fed has not tightened policy by 75 basis points since late 1994.
The two-year yield has risen as much as 60 basis points to 3.4% over the past two trading sessions, after an elevated inflation report for May shattered hopes of a peak in US consumer prices. The rate on the 10-year note climbed as much as 28 basis points to 3.43%, and up from below 3% late last week, surpassing the benchmark’s peak from late 2018 and is now at its highest level since 2011.
The pressure on front-end yields sparked renewed flattening in the curve late on Monday, a signal from the bond market that tighter Fed policy will slow the economy and possibly herald a slump in activity.
Financial conditions are also significantly tighter, hitting equities and credit. The S&P 500 hit a bear market, falling 22% from this year’s peak. The 10-year inflation-adjusted yield -- also known as the real yield -- surged to the highest since 2019, climbing from a low of 0.19% on Friday.
“The terminal rate can push to 4%, although it may be hard to see that outcome if the economy does slow and enters a recession,” said Jason Bloom, head of fixed income and alternatives ETF product strategy at Invesco. “The market is tightening financial conditions for the Fed and they may not have to raise rates as high as currently seen.”
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