Why markets are suddenly betting on US interest rate hikes again

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Markets had been fairly settled on one idea until recently. The US Federal Reserve would start cutting interest rates this year as growth slowed and inflation cooled. That view is now shifting quite quickly, the Financial Times reported.

A sharp change in expectations

Investors are now beginning to price in the possibility that interest rates could actually go up instead of down. Futures markets are showing close to a 50 per cent chance of a rate hike by October, a big turnaround from earlier expectations of two or three rate cuts this year.

This shift has already shown up in bond markets. Yields on short-term US government bonds, especially the two-year Treasury, have moved higher as traders adjust their positions. That’s usually a sign that markets are bracing for tighter monetary policy.

The oil shock behind it

The main driver behind this change is the ongoing conflict in the Middle East. Oil prices have risen sharply, with Brent crude jumping significantly since the fighting began and key routes like the Strait of Hormuz facing disruption.

Higher oil prices tend to feed directly into inflation. Fuel costs rise, transport becomes more expensive, and that eventually pushes up prices across the economy. Federal Reserve chair Jay Powell has already indicated that the conflict is likely to add to inflation pressures.

For investors, that’s where the worry comes in. If inflation starts picking up again, the Fed may not be able to go ahead with rate cuts like many had expected. It might even have to move in the opposite direction.

A tough spot for the Fed

That leaves the Federal Reserve in a bit of a bind. On one side, parts of the US economy, including the job market, have already started to show signs of slowing. That’s what led many to expect rate cuts in the first place.

On the other side, rising oil prices are pushing inflation higher again. And if inflation stays elevated, the Fed has less room to ease. Raising rates could help bring prices under control, but it also risks putting more pressure on growth.

Some investors think the market may be getting ahead of itself. Even though expectations have shifted, they argue it would be difficult for the Fed to actually raise rates without hurting the economy.

Why this matters beyond the US

This isn’t just a US issue. What the Fed does tends to ripple across global markets. Higher US rates can strengthen the dollar, tighten liquidity worldwide and create pressure for other central banks, including in countries like India, to respond.

For now, what’s clear is that the outlook has become more uncertain. A few weeks ago, the conversation was about when and how quickly rates would come down. Now, the possibility of them going up again is back on the table.

And as long as the conflict continues to keep oil prices elevated, that uncertainty is likely to stay.