Rates spark: A Fed hike could shake sentiment

We don't think the FOMC will hike rates, but markets see a 30% probability that it does. The front end of the EUR and GBP markets can move even higher on a hawkish tilt. Longer-dated global rates, however, could find resistance to follow through, especially if the positive market sentiment gets challenged by a tightening of financial conditions.

Fed will surprise, and global rates should watch

Global markets will be bracing for the Fed meeting as we’re bound to have a surprise, but the direction remains up for debate. Markets seem to settle at around a 30% probability of a hike, which means both a hold and a hike should push rates around. The narrative around the decision matters too, especially the stance of Fed Chair Kevin Warsh if the option to hike rates is chosen. He might not endorse the move but simply deliver it.

Also, EUR and GBP markets should keep an eye on the aftermath of the Fed, as its recent hawkish turn has had clear spillovers in the form of higher real rates elsewhere. Oil prices, alongside inflation expectations, remain the biggest daily rate drivers, but a rise in real rates has also contributed some 50bp to nominal 2Y swap rates over the past months. And with sentiment choosing to take a positive stance on the economic outlook, European rate markets can probably still permit an even more hawkish positioning.

We could also imagine a scenario where market sentiment takes a hit if the Fed hikes as risk assets suffer from tighter financial conditions. Already we’re seeing increasing jitters in equities on the back of AI uncertainties. In this case, the curve reaction should be of interest. Shorter rates would be pushed upward, but longer rates might find resistance to follow. In this case, the positive global growth outlook could be challenged. Expect flatter global curves in this outcome.

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