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 the globe. Shipping through the Strait of Hormuz has been obstructed, and energy facilities in the Persian Gulf have been attacked, leading to severe damage to energy supply, skyrocketing oil and gas prices, and a rapid rebound in global inflation expectations. As a result, the policy expectations of major global central banks have undergone a dramatic and violent reconstruction.

Just a month ago, the market was pricing in 2-3 rate cuts by the Federal Reserve within the year; however, as inflation concerns quickly heated up due to the energy shock, the market swiftly switched to accounting for rate hikes, even the tail risk of emergency rate hikes. The OIS market has priced in about a 50% probability of the Federal Reserve raising rates before December this year; meanwhile, demand for trades linked to SOFR, betting on a rate hike by the Federal Reserve within two weeks, has surged.

The global bond market has also experienced severe selling pressure, with U.S. Treasury yields rising significantly across all maturities, showing a notable bear flattening of the yield curve. The sharp turn 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 adjusted significantly, while stocks and credit assets are under pressure, and cross-asset correlations have risen sharply.

More importantly, financial conditions have significantly tightened even before the Federal Reserve has taken action. The rapid increase in short-term rates has directly raised financing costs, combined with adjustments in the yield curve, creating preemptive constraints on corporate investment and household consumption. This means that even if the Federal Reserve keeps rates unchanged, the market itself has already begun to substitute rate hikes.

At the same time, there is a significant divergence between market expectations and the guidance and statements from the Federal Reserve officials. 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 lean towards “keeping rates unchanged for a longer time,” even leaving the possibility of rate cuts within the year. This divergence in expectations itself reflects a high level of sentiment and tail risk premium included in the current pricing.