Market suddenly shows panic betting: If the war gets out of control, the Federal Reserve may implement emergency rate hikes

Author: Xiao Yanyan, Jinshi Data

Bond traders are feeling panic due to the potential escalation of the Iran conflict, seeking to hedge against the worst-case war outcome — that the Federal Reserve may be forced to raise interest rates in the coming weeks.

In the options market tracking Federal Reserve policy, demand for bets linked to the Secured Overnight Financing Rate (SOFR) has emerged, and these bets correspond to a scenario where rate hikes could occur as early as in two weeks. If the bond market significantly raises rate hike expectations before the Federal Reserve policy meeting on April 29, these trades will profit.

This surge in hedging demand for an emergency rate hike marks a sharp reversal in market sentiment. Just a month ago, the market expected up to three rate cuts of 25 basis points by the end of the year. Since the outbreak of war on February 28, swap market traders have begun to price in about a 50% probability of rate hikes before December, putting short-term U.S. Treasuries at further risk of repricing.

Jeff Schuh, head of the interest rate department at Constitution Capital, stated that while the latest bets do not reflect the market’s baseline scenario, they do indicate growing market concerns: rapidly rising inflation will pose risks for investors who have been long on U.S. Treasuries in recent months.

Schuh noted that as rising oil prices have reignited concerns about inflation, traders have liquidated a large number of long positions in U.S. Treasury futures. The sell-off of SOFR futures and the upward movement of the entire U.S. Treasury yield curve have caught many large funds off guard. He pointed out that for funds looking to manage interest rate risk, such trades “make the risk of liquidation appear more manageable in 90% of cases, serving as a cheap stopgap measure.”

Currently, the interest rate swap market is only pricing in a rate hike of 3 basis points for the April 29 policy meeting, which means the probability of a 25 basis point rate hike is 12%.

Conflicting signals from both the U.S. and Iran regarding the cessation of hostilities have further heightened hedging demand. On Thursday, Iran stated it had rejected the U.S. proposal to end the war and put forth its own conditions; meanwhile, President Trump announced the extension of the previously set five-day deadline for reaching an agreement by 10 days.

This has forced traders to deal with unprecedented uncertainty regarding the Federal Reserve’s policy outlook. At the same time, Kevin Warsh is set to succeed Jerome Powell as Federal Reserve Chairman this summer, while Trump continues to pressure for lower interest rates.

Schuh stated, “Even though Warsh is about to take over, there is enormous uncertainty regarding interest rate trends; how long it will take him to reach consensus or a ‘majority’ on the board to push for rate cuts remains unresolved.”