Bet on both sides at the same time! The market bet on a short-term aggressive interest rate hike on the one hand, and a rate cut after two years on the other

After the release of the U.S. January CPI, which exceeded expectations and continued to hit the highest growth rate in four decades, the market on the one hand bet that the Fed would raise interest rates more aggressively during the year and shrink the balance sheet, but on the other hand, it also bet that the Fed's tightening policy would lead to an economic slowdown in two years, and thus return to the old road of volume.

A one-time rate hike of 50 basis points in March is expected to double

Previously, when Bank of America gave the most aggressive forecast of 7 rate hikes in the year, the market was not impressed. However, after the release of the CPI data, this has increasingly become a common expectation of the market.

The latest data released by the U.S. Bureau of Labor Statistics showed that the U.S. CPI broke the watch again in January, up 7.5% year-on-year, higher than the market's previous expectation of 7.3%, and also higher than the previous 7%, the fastest increase since February 1982. In addition, the January CPI and January core CPI growth rate was both 0.6%, unchanged from the previous value, and did not slow to 0.4% as expected by the market.

After the data was released, the interest rate futures market now expects the probability of the Fed to raise rates seven times a year to 61%. The market also bet that in the three meetings in March, May and June, the Fed will raise interest rates by a cumulative 100 basis points, which means that the market believes that one of the meetings may raise interest rates by 50 basis points. The market currently sees the March meeting as the most likely 50 basis point rate hike, and as of midday on Thursday, the probability of this expectation has risen to 62% from less than 30% on Wednesday night. The market also expects the Fed to raise interest rates by a cumulative 164 basis points throughout the year.

Another tool that reflects market expectations, CME FedWatch, currently expects a 50 basis point hike in March with a nearly 94% probability.

The higher rise in the 2-year Treasury than the 10-year Treasury also reflects the market's expectations for a more aggressive interest rate hike by the Fed in the near term. After the CPI was announced, the benchmark 10-year Treasury yield broke through the 2% mark for the first time since August 1, 2019, rising by more than 6 basis points, while the more interest-sensitive 2-year Treasury yield rose by more than 10 basis points during the day.

Barclays said in a research note on Thursday that it had raised the Fed's forecast for rate hikes this year from 3 to 5. "The January CPI data released today exceeded our previous expectations, coupled with the previous January non-farm payrolls report, we instead supported the Fed's more forward-looking policy response." The bank expects its latest forecast that the Fed will raise the federal funds rate to 1.75 to 2.0 percent for the period ending mid-2023. This final value is 25 basis points higher than its previous forecast, which is also 6 months ahead of previous expectations. That means Barclays expects the Fed to raise rates faster and more violently.

Barry Gilbert, an asset allocation strategist at LPL Financial, said inflation surged unexpectedly again in January and markets continued to fear that the Fed would take aggressive measures. While things may start to improve, fears of excessive Fed tightening will not disappear unless there are clear signs that inflation is under control.

Paul Jackson, global director of asset allocation research at Invesco, said high inflation data had raised expectations that the Fed would accelerate monetary tightening, with the 10-year Treasury yield likely to break through 2.5 percent this year, with a relatively greater impact on growth-dominated S&P 500 in U.S. stocks.

This year's FoMC voting committee and St. Louis Fed President Bullard's remarks on Thursday also further corroborated and reinforced the market's expectations. Bullard said the Fed's focus is on fighting inflation, and he prefers the Fed to raise interest rates by 100 basis points by July 1, supporting a 50 basis point hike in March, while supporting a balance sheet reduction starting in the second quarter, and then deciding the next monetary policy path based on the latest data in the second half of the year.

After Bullard's speech, the 10-year Treasury yield rose further, rising above 2.05% in the late session of the US stock market, and the 2-year US Treasury yield rose more than 20 basis points above 1.60% in the afternoon session of the US stock market, hitting a new high since January 2020.

Bet on the restart volume wide after two years

While expectations of fed rate hikes this year are becoming increasingly aggressive, further flattening of the yield curve after the data is released also signals that the market is betting that the Fed will restart its volume-wide policy in the near future. The US 2-year/10-year yield spread narrowed to 43.7 basis points, the narrowest since August 2020.

In addition, from the perspective of forward curve pricing, the market expects the Fed to restart rate cuts in about two years. Specifically, after the data was released, the 1-year forward 2-30-year US Treasury yield was inverted; the 2-10-year US Treasury yield curve tended to be flattened; and the 7-10 year US Treasury yield curve briefly inverted.

Most notable is the 5-30-year US Treasury yield curve. Currently, the US 30-year Treasury yield is 2.299%, down 0.42% during the day, while the 5-year US Treasury yield is 1.951%, up 0.34% during the day, and the last time the spread reached its current level of flatness was in 2018, when the Fed's monetary policy shifted from "hawkish" to "dovish".

Financial blog Zerohedge commented that the sharp flattening or even inversion of the long-term and short-term yield curve means that the market is setting prices for the Fed to cut interest rates in the near future, and the market expects the Fed to aggressively raise interest rates in order to control inflation, and then have to return to the old path of interest rate cuts and quantitative easing due to the threat of recession.