Market participants in the federal funds rate market are increasing their bets that the Federal Reserve could begin raising interest rates as early as July. This previously unthinkable move could be derailed by a series of upcoming economic data releases.
The probability of a rate hike at next month's policy meeting remains relatively low. Current pricing in interest rate swaps reflects approximately 9 basis points of tightening, equivalent to about a 36% chance of a 25-basis-point increase. Despite this, the likelihood has risen significantly; it was virtually zero before the new Fed Chair, Kevin Warsh, shifted the focus toward price stability.
Since the June 17 policy meeting, open interest in the August federal funds rate futures contract—representing the total volume of new trading positions held by investors—has risen rapidly. The swift accumulation of new positions has been skewed toward sellers, indicating traders are taking short positions in this contract. Such positions would benefit if the probability of a rate hike continues to increase.
These speculative bets are gaining momentum even as options traders had previously sought to hedge against the number of rate hikes already priced in by the market. These positions could face their first test as early as Thursday with the release of labor market data. Any signs of weakening job growth could diminish the odds of a July hike, putting the newly established short positions at risk.
Open interest in the August federal funds rate futures contract, which tracks the policy statement due on July 29, has increased by approximately 30%. It has risen from about 454,000 contracts the day before the June policy statement to nearly 590,000 contracts as of Monday's close. Since Warsh opened the door to two-sided risks in central bank policy decisions, daily trading volume during this period has consistently been above average.
Further out on the yield curve, market participants are beginning to show interest in establishing more bullish positions, betting that longer-dated U.S. Treasury securities will perform better.
"Long-term U.S. Treasury yields appear to have peaked in mid-May, with long-duration bonds delivering positive returns even amid high equity market volatility and a sideways trading range," said Jason Vaillancourt, Chief Portfolio Strategist at Columbia Threadneedle Investments.
JPMorgan Asset Management Portfolio Manager Priya Misra stated that the flattening of the yield curve "reflects a shift in market risk focus from the labor market to inflation."
A series of data releases in the coming weeks, including the June employment report and the consumer price report, will influence the direction of the yield curve and traders' views on interest rate hikes.
"If inflation data remains robust and labor data also shows strength, the curve could continue to flatten as the market prices in more rate hikes," Misra said. "Given my view that the peak in inflation is behind us, I am less inclined to initiate flattening trades now, but it could very well become a painful trade direction for the market."
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