Trader Bets on June Fed Rate Hike Mount Despite Debt-Limit Paralysis

(Bloomberg) — Bond traders stepped up wagers on an interest-rate increase by the Federal Reserve by July spurred in part by surging UK policy-rate expectations after an upside surprise by British inflation data.

Most Read from Bloomberg

Swap contracts temporarily priced in as much as 12 basis points of tightening in June, a new high since the last central bank hike on May 3, despite the persistent threat that lawmakers will fail to raise the US debt ceiling in time to avoid a financial crisis. The July contract was priced for 17 basis points of tightening in late trading. Treasury yields were higher on the day led by policy-sensitive short maturities.

With a little over a week remaining until the projected date when the US government will run out of cash, expectations for a June rate increase may signal faith not only that an agreement will be reached, but that it won’t entail spending cuts that could cripple the economy.

“If the data between now and June 14 warrants another hike, then I think, they do hike,” said Gregory Faranello, head of US rates trading and strategy for AmeriVet Securities. However, “the debt ceiling ranks high as a risk factor to the outlook.”

Economists at JPMorgan Chase & Co. said Wednesday that the odds of reaching the so-called X-date without an agreement are 25% and rising.

Recent commentary by Fed officials has largely sidestepped the question of how failure to resolve the debt ceiling could affect policy, focusing instead on how to strike a balance between still-elevated inflation and signs that the central bank’s 10 rate increases totaling 5 percentage points in the past 14 months are beginning to cause financial stress that warrants a pause in June.

Story continues

Minutes of the central bank’s May meeting released Wednesday afternoon showed that officials were split on the need to tighten policy further, wiht and many “focused on the need to retain optionality.”

Swap rates anticipate a peak in July — pricing in most of a quarter-point hike by then — and then at least one rate cut by the end of the year. Traders upped their buying of rate options Wednesday that become profitable should the Fed’s policy benchmark remain higher for longer than what the market is currently pricing in.

“If we get a debt ceiling resolution, the market will go to a coin toss immediately on pricing for the June meeting,” said Jonathan Duensing, head of US fixed-income at Amundi US. “Then it really comes down to the data as to whether the hawks win out over the doves at the FOMC.”

In the UK Wednesday, money-market rates rose to levels consistent with the BOE policy rate peaking around 5.5%, compared to 5.1% on Tuesday, after the fastest increase in services and core prices in more than three decades.

Negotiations between the Biden administration and the Republican majority in the House of Representatives about the debt ceiling are set to resume at noon in Washington. Failure to raise or suspend it will cause the US government to run out of cash as early as June 1, possibly leaving it unable to pay creditors. As a result, Treasury bills maturing in early June traded at yields north of 6% Wednesday, compared with yields under 4% for bills maturing this month.

“If the debt-ceiling impasse is resolved uneventfully — with a comfortable margin before the X-date and only small spending cuts — a 25-basis-point hike will be on the table in June,” Anna Wong, chief US economist at Bloomberg Economics, said in a report. Her base case is for a pause, though, as “a last-minute deal on the debt ceiling will raise financial volatility ahead of the meeting and weigh on the economic outlook.”

–With assistance from Liz Capo McCormick and Edward Bolingbroke.

(Adds FOMC minutes, updates rate levels)

Most Read from Bloomberg Businessweek

©2023 Bloomberg L.P.