The Federal Reserve could shock markets this week with a bigger-than-expected 75 basis point rate hike, futures data indicated Monday, as investors react to last week's white-hot inflation data and its impact on the world's biggest economy.
The CME Group's FedWatch suggests a 33.5% chance of a 75 basis point rate increase on Wednesday, up from just 3.1% a week ago, following Friday's Commerce Department reading of consumer price inflation, which surged to a 40-year high of 8.6% last year.
That would take the FedFunds rate to a range of 1.5% to 1.75% when the decision is made at 2:00 pm Eastern Time. The chance of a follow-on hike of 75 basis points in July, in fact, is now 18.2%.
Record high gasoline prices, which nudged past the $5 a gallon mark last night, according to data from AAA, will continue to drive headline inflation rates as crude oil holds firmly above the $120 per barrel mark, while food prices extend their recent run-up amid transport snarls and uneven planting seasons.
Bond market reaction to both the Friday reading and the near-term change in rate forecasts has also been swift, with benchmark 10-year note yields rising to a multi-year high of 3.389% in late New York trading, dragging 2-year notes to 3.363% and the highest levels since 2007.
The moves have put the spread between 2-year and 10-year notes at just 2 basis points after briefly inverting during the overnight trading session.
According to a study from the San Francisco Federal Reserve, a sustained inverted yield curve has preceded all of the nine recessions the U.S. economy has suffered since 1955, making it an extremely accurate barometer of financial markets sentiment.
Treasury yields, which move in the opposite direction of prices, have been climbing for much of the month, in fact, following the Fed's deployment of a powerful, but lesser-known, inflation-fighting tools: the slow reduction of its $9 trillion balance sheet.
The Fed will begin selling around $47.5 billion worth of Treasury and mortgage-backed bonds each month, for the next three months, as part of its overall strategy to add upward pressure on market interest rates and slow demand in the world's largest economy. The first of the sales, ironically, will begin Wednesday.
The pace of those sales will accelerate further, however, to around $95 billion a month by September, putting the Fed on pace to dump around $3 trillion worth of securities on to the market over a span of three years - a rate more than double the last time the Fed began its so-called "quantitative tightening" in 2018.
"Because the Fed overstayed its welcome in the mortgage-backed securities market, housing, which is the stickiest form of inflation, promises to remain stubbornly high," Danielle DiMartino Booth, CEO and chief strategist of Dallas-based Quill Intelligence.
"In addition to still-rising energy prices, the Fed will have no choice but to continue tightening to combat the biggest effective tax on income U.S. households have seen in generations," she added.
DiMartino Booth also dismisses the notion of a "Goldilocks" outcome from the Fed's rate hikes, calling such expectations a "mockery".
Consumer sentiment is at record lows and jobless claims have surged since bottoming in mid-March, leaving little doubt that the U.S. has entered recession. The only questions that remain are the length and depth of the current contraction."
Last week, Treasury Secretary Janet Yellen told a New York Times 'Deal Book' event that there is "nothing to suggest that a recession is in the works".
The U.S. economy did contract sharply over the first quarter and is now only expanding at a 0.9% clip, according to the Atlanta Fed's GDPNow forecasting tool.
