On the eve of the Federal Reserve's interest rate decision, uncertainty in the bond market has notably intensified. While most traders still expect policymakers to hold rates steady, some Wall Street institutions, including Citadel Securities and PGIM, are betting on the possibility of a surprise rate hike at the second meeting chaired by new Fed Chair Kevin Warsh.
This shift in expectations is seen as a significant signal of a change in the Fed's communication style. Since taking office, Warsh has sought to move away from the previous reliance on forward guidance, refraining from clearly signaling policy direction to the market in advance.
If the Fed chooses to raise rates, it would help Warsh build policy credibility in fighting inflation. As a result, some market participants believe the probability of a rate hike at this week's meeting is rising. Traders have recently increased their hedging positions against a surprise hike to record levels, reflecting market anxiety.
"Warsh is still a bit of a wild card; he's been quite adamant that he's not interested in forward guidance," said Joe Boyle, a fixed income investment specialist at Hartford Funds. "He's not interested in telegraphing any signals, but maybe there will be slip-ups, or maybe he will do something that is perceived as forward guidance."
Multiple Institutions Lean Toward a Rate Hike
The chorus of voices supporting a rate hike has been growing recently. Frank Flight, head of macro strategy at Citadel Securities, adjusted his previous forecast this week, shifting his baseline expectation toward a rate hike.
Flight believes a rate hike would "decisively end the era of forward guidance" while also strengthening the Fed's independence.
Lou Crandall, chief economist at Wrightson ICAP, said there is no compelling reason for the Fed not to raise rates.
Robert Tipp, global head of bonds and chief investment strategist at PGIM, argued that the market is underestimating the likelihood of a rate hike this week.
"He's really laid the groundwork for a rate hike," Tipp said, "Delaying the decision now would increase the likelihood of a 50-basis-point hike in September."
Harley Bassman, a veteran bond market commentator, went further, suggesting the Fed should take more aggressive action. In a report published Tuesday on the financial commentary website The Convexity Maven, he wrote that the Fed should "rip the band-aid off" and raise rates by 50 basis points directly.
Bassman believes such a move would both enhance the Fed's credibility in fighting inflation and fend off political pressure from President Donald Trump to lower borrowing costs.
"A 50-basis-point hike signals that there's a new sheriff in town, and he's not beholden to the President," Bassman wrote.
Market Hastens to Hedge Policy Shift; Traders Still Lack Clarity on Warsh's Path
The uncertainty surrounding Fed policy is driving traders to increase their risk hedging. Open interest in August federal funds futures contracts surpassed the record set in October 2024 on Friday, reaching 909,714 contracts. Data released Monday showed the figure further climbed to 967,136. This trading pattern reflects an unusually deep divide over the Fed's next move.
Michael Ball, a strategist at Bloomberg, said the market is entering a relatively uncharted phase where the Fed Chair may adjust policy without clear advance signals.
He believes that while this approach could cause short-term shocks, risk assets could still find support if investors ultimately endorse the policy's rationale.
The recent repricing of interest rates has been driven by two main factors: on one hand, the rebound in energy prices following the escalation of the US-Iran conflict, fueling concerns about inflationary pressures; on the other, the resilience of the US labor market.
Although a retreat in oil prices on Tuesday boosted US Treasury prices, traders are still betting that the Fed could raise rates by 25 basis points before September and anticipate cumulative rate hikes approaching 50 basis points by March next year.
"The market is pricing in the real risk of a Fed rate hike," said Mark Cabana, head of US interest rate strategy at Bank of America. Investors are "still trying to understand how the Fed will operate under Chair Warsh."
According to a research report released Friday by Bank of America's strategy team led by Cabana, the team expects the Fed to hold rates steady this week but believes regional Fed presidents Lorie Logan and Beth Hammack could dissent.
"If the market can't rule out a rate hike, neither can we," the team wrote.
$BMO Capital Markets$'s head of US interest rate strategy, Ian Lyngen, noted in a report Tuesday that since 2015, traders' average prediction error for the final rate outcome the day before a Fed decision has been 2.4 basis points.
"The market's knee-jerk reaction to the FOMC statement will be more pronounced than usual," Lyngen said.
Jonathan Pingle, chief US economist at UBS, said he has not felt this uncertain about an upcoming Fed policy decision in nearly two decades. The last comparable period was when Ben Bernanke first became Fed Chair.
Pingle believes Warsh lacks a sufficient track record of policy decisions for reference, and recent divisions among Fed officials make it harder for the market to gauge the future direction. He said he cannot rule out the possibility that Warsh himself will play a decisive role within the committee.
"Given his current ability to move the committee's median stance, he will determine the policy direction for the next few meetings, and we really have no clue about Kevin Warsh's monetary policy thinking," Pingle said.
