Interest rate decision to be announced soon; market betting on a 94% probability of a rate hike—if unchanged, it could become the biggest “dovish surprise” in over 30 years

According to Zhitong Finance APP, as the Federal Reserve prepares to announce its rate decision on Wednesday, bond traders have almost fully priced in a rate hike as the final outcome. Rate swaps tied to the Fed's meeting dates currently suggest there is about a 94% probability that Fed Chair Walsh and his colleagues will raise the benchmark rate by 25 basis points, with the market pricing in about 23 basis points of tightening.

The current target range for the U.S. federal funds rate is 3.50%-3.75%. If the Federal Reserve raises rates by 25 basis points as the market expects, the policy rate range will rise to 3.75%-4.00%. Historical experience shows that when market expectations for a rate hike reach this level, the Fed has almost never disappointed traders. According to data compiled by Bloomberg since 2008, whenever the market-implied probability of a rate hike reaches such a high, the Fed ultimately implements a rate hike.

Deutsche Bank strategists further pointed out, based on federal funds futures data, that if the Federal Reserve unexpectedly stays on hold this Wednesday, it would be the “largest dovish surprise” in a routine policy meeting since 1994, when the Fed began formally announcing rate decisions after FOMC meetings.

Caesar Maasry, Head of Investment Research at Lunate, said: "The market is not prepared for rates to stay unchanged or for a dovish rate hike."

Rate hike probability rises to 94%, Wall Street collectively shifts after inflation data

The market's expectation for a rate hike in September was not always so firm. On the day of the Federal Reserve’s policy meeting at the end of July, traders believed the probability of a rate hike was only about 38%, and ultimately the Fed chose to keep rates unchanged. Due to Walsh’s vagueness on how to deal with inflation, long-term U.S. Treasuries came under notable selling pressure at the time.

But the situation is now completely different. Expectations for a September rate hike have surged since last month. At that time, Walsh said the Fed would ensure that inflation cools at a "fast enough pace," leading the market to increase bets on further tightening of monetary policy.

By last Friday, after the release of U.S. consumer price data, traders were almost fully betting that the Fed would raise rates in September. The data showed that U.S. inflation still showed no clear signs of cooling, and the inflation rate has remained above the Fed’s target for over five years in a row.

After the data was released, many large Wall Street financial institutions quickly revised their rate forecasts, changing their previous prediction of a "hold" in September to a 25 basis points rate hike. This pushed the market-implied probability of a rate hike further up to around 94%.

Walsh changes Fed communication approach, increasing risk of policy surprises

For a long time, the Federal Reserve has tried to avoid surprising financial markets with its rate decisions, especially when raising rates, since unexpected monetary policy tightening could trigger sharp volatility in the bond, stock, and forex markets.

However, since Walsh became Fed Chair in May of this year, policy decision uncertainty has increased. Walsh changed the Fed's longstanding communication approach and no longer signals the next policy move to the market as clearly in advance. This means that even when expectations are highly aligned, traders still have to face the possibility of unexpected policy decisions.

The July policy meeting was a clear example. Until the day of the announcement, the market was still pricing in a 38% probability of a rate hike, but the Fed ultimately did not act.

However, compared to July, confidence in a rate hike is now significantly higher among market participants. A 94% implied probability means that for the vast majority of bond traders, the question for Wednesday is no longer "Will the Fed hike rates?" but rather "What policy signals will Walsh release after the hike?"

Some traders hedge against 'black swan' events, short-term rate options demand surges

Despite the fact that a rate hike is almost fully priced in, some investors are still hedging for the scenario where the Fed unexpectedly holds rates steady.

On Tuesday, demand surged for short-term interest rate options that would profit if the Fed unexpectedly keeps rates unchanged, indicating that some traders are willing to pay to protect against low-probability events.

The reason is that if the Fed holds rates steady when the market has priced in a 94% probability of a rate hike, the impact on asset prices could be much larger than during a typical policy meeting. On one hand, short-term Treasury yields could fall sharply; on the other hand, since the market had been highly confident about further tightening, an unexpected pause could also be read as a distinctly dovish policy shift.

Therefore, even though the probability of such a scenario is low, the potential market volatility is enough to attract some investors to take out protection in advance.

Surging oil prices intensify inflation concerns; 10-year Treasury yields reach highest since 2007

This Federal Reserve meeting is particularly crucial for the bond market, because long-term U.S. interest rates have risen to rare heights in nearly two decades.

On Tuesday, the 10-year U.S. Treasury yield reached its highest level since 2007. Recent sharp increases in oil prices have further intensified concerns about a resurgence of inflation and have prompted investors to reassess the Fed’s policy path going forward.

Rising energy prices could transmit to overall prices through gasoline, transportation, and corporate production costs. If inflation stays above target, the Fed might not only need to hike in September, but the market could also further increase expectations for additional rate hikes in the future.

Therefore, for the bond market, Wednesday’s policy decision is only the first layer of risk. More important is whether Walsh will signal that this rate hike is a one-off action, or the start of a new tightening cycle.

Alex Cohen, a Bank of America FX strategist, said: "Tomorrow's Fed meeting will be the most important we’ve had in some time. With the market already pricing in a roughly 90% probability of a hike, the Fed choosing to hold at this time would be almost unprecedented."

The market focus shifts to the policy path after the rate hike

This Fed meeting also has an unusual political backdrop.

U.S. President Trump personally nominated Walsh as Fed Chair, but during former Chair Powell’s term, Trump had repeatedly and publicly demanded that the Fed cut rates sharply. Now, with Walsh leading the Fed for just a few months, the market is nearly certain the central bank will hike rates further, forming a sharp contrast with Trump’s previous longstanding advocacy for lower rates.

For the market, if the Fed hikes rates 25 basis points as expected on Wednesday, what will truly determine the next stage for Treasuries, the dollar, or even U.S. stocks, will likely be Walsh’s statements about the future policy path.

Against a backdrop of stubborn inflation, rising oil prices adding further price pressures, and 10-year Treasury yields at their highest since 2007, investors will focus on whether the Fed still emphasizes fighting inflation and whether further rate hikes remain possible this year.

Given the roughly 94% probability currently priced in, a 25 basis points rate hike has been heavily digested by the market. In contrast, if the Fed unexpectedly holds rates steady or if Walsh delivers clearly dovish signals, these could pose the largest market risks at this meeting.