Market pricing in rate hikes ≠ Federal Reserve imminent rate hikes? Wall Street: This path is not easy to take...

Ask AI · What’s the logic behind PIMCO’s counter-trend bond investing?

China Finance Network (3月25日讯, edited by Xiaoxiang) For global financial markets, a major shift caused by the fighting in the Middle East this month is, without a doubt, prompting investors to start betting that the next move by the Federal Reserve will be rate hikes. However, many insiders say that the ongoing fragility of the U.S. labor market and the surge in oil prices pose downside risks to economic growth, which may make it difficult for the Federal Reserve to actually implement rate hikes……

The pricing in the interest rate futures market shows that on March 19, the federal funds rate futures first priced in a 6% probability of a rate hike by the Federal Reserve in April. Since then, it has remained within positive territory. This marks the first time since December 2023 that investors have believed the likelihood of a rate hike at the next policy meeting is higher than the likelihood of a rate cut.

This shift by investors highlights the significant uncertainty it may bring to the U.S. economy from the chain reactions that could be triggered by the Iran-U.S. conflict and the surge in oil prices. But economists and analysts who closely monitor the Fed’s moves say the likelihood of a rate hike in the near term remains very low……

Rate-hike expectations are one thing; seeing it actually happen is another?

Citi economist Veronica Clark said, “Of course, the oil shock is a new inflation risk, but if there are other effects, it’s also a negative economic growth shock, and could even be detrimental to employment.”

The policymakers at the Federal Reserve seem to hold the same view. In the first set of rate dot plots released after the outbreak of the Middle East war, none of the 19 Fed policymakers predicted a rate hike this year; only one predicted a rate hike in 2027. In fact, most officials still suggest that they will cut rates again.

At a press conference after last week’s policy meeting, Fed Chair Jerome Powell told reporters that they did indeed discuss the possibility that the next step could be a rate hike during the meeting. But he added that, even so, “an overwhelming majority” of members of the Federal Open Market Committee still believe that a rate hike is not their baseline scenario.

Fed officials subsequently also pointed out quickly that the impact of the oil price shock on inflation may be temporary, and that it takes months for adjustments to interest rates to affect the economy. This means that any downward pressure on inflation from rate hikes may only become visible after the period of price increases ends and even after inflation begins to retreat.

Many analysts in the industry also said that to justify a rate hike, the surge in energy prices must persist for a long time, spread to other commodities and services, and also be accompanied by a labor-market-driven trend of wage growth.

Even though the memory of the high-inflation shock triggered in 2022 by the Russia-Ukraine conflict may make investors worry, the economic backdrop at that time was clearly different from today. The inflation measure preferred by the Fed had already risen to more than 6% at the beginning of that year, and the unemployment rate had fully recovered from the pandemic. Against the backdrop of a tightening labor market, companies competed to hire workers, further exacerbating inflation pressures.

By contrast, as the U.S. enters 2026, its labor market is experiencing a prolonged lull in hiring. While there were signs of stabilization at the end of last year, in February officials unexpectedly saw a decline in nonfarm payroll employment.

In addition, there is another reason to question the rate-hike outlook: once the next Fed chair nominee Kevin Warsh, nominated by Trump, is finally confirmed by the Senate, the White House could put pressure on him to lower interest rates. In a recent research report led by analysts at Bank of America, Aditya Bhave wrote that given Warsh’s recent remarks emphasizing the urgency of rate cuts, it is hard to imagine he would return to a hawkish stance after taking over as chair.

So, how should people view the rate-hike expectations that have emerged in the interest rate futures market right now? On this issue, Molly Brooks, a rates strategist at TD Securities, said that some of these trades are less about forecasting and more like “insurance policies” against unlikely but highly destructive outcomes.

Brooks noted, “Before the initial strike on Iran, we were all watching the fundamentals, and everyone leaned toward rate cuts. And once people see the oil shock, concerns about inflation roll back in again.”

PIMCO favors a contrarian trade: buy bonds!

Worth noting is that with the Middle East conflict and shifting expectations for global central bank policy toward hawkishness, market volatility has intensified, and Pacific Investment Management Company (PIMCO) is currently strongly promoting ‘contrarian investment opportunities.’

This month, global bond markets have faced their worst selloff since October 2024. That is because with oil prices surging due to the conflict and the risk of inflation returning, traders are preparing for the possibility of rate hikes later this year in the UK, Europe, and the U.S. However, PIMCO recommends that investors increase their holdings of global bonds that are more sensitive to interest rates.

In the view of PIMCO economists Tiffany Wilding and global head of fixed income Andrew Balls, the energy shock raises the likelihood of stagflation—meaning weak economic growth, high unemployment, and high inflation coexisting.

In their report, they wrote, “It’s unlikely that central banks will keep up with the market’s recent repricing of expectations for policy rates, and the effects will be transmitted more directly to vulnerable households, small businesses, and credit markets.”

“Actually, the market’s instinctive reaction to tighter financial conditions and a more hawkish stance in monetary policy has already, to a large extent, done the hawkish work for policymakers,” they wrote. If inflation keeps rising in the near term and the economy weakens, “the central bank may need to take more aggressive easing measures.”

During this month’s highly volatile trading, U.S. Treasury yields across the 2-year to 10-year segment were at one point broadly up by nearly 50 basis points. Currently, short-term Treasury yields are approaching 4%, and the 10-year yield is hovering around 4.37%, close to the upper end of the 4%-4.5% range that has been the major level over the past year.

PIMCO also mentioned a period last year when the bond market saw similarly sharp volatility—when U.S. tariffs imposed on trade partners were far higher than expected, which also triggered a brief spike in U.S. Treasury yields. “Similar to the volatility after the U.S. announced additional tariffs in April 2025, the rapid repricing of central bank expectations in response to the Middle East conflict caused localized volatility and created an opportunity for contrarian investing,” Wilding and Balls wrote.

PIMCO’s main investment recommendations for investors over the next 6 to 12 months include:

PIMCO favors “moderately overweighting duration,” meaning increasing allocations to global bonds with higher sensitivity to interest rates— the firm believes the U.S. Treasury market remains a well-recognized source of ‘safe-haven’ returns, which can bring diversification benefits to a portfolio, and that the rationale for global diversification remains strong because differences between countries are becoming more apparent, allowing active investors to profit from them;

Rather than assume the direction of global markets, investors should benefit from risk exposures targeted at specific developed countries and emerging markets—these markets offer attractive real yields and reliable policy frameworks;

For portfolios with increased stock market exposure, the rise in high-quality bond yields should be treated as the “actual timing to consider rebalancing”;

In private credit, when signs of credit stress become more visible at the end of the cycle, it is necessary to carefully select issuers, prudently assess pricing and liquidity terms, and prioritize investing in high-quality investments supported by collateral;

PIMCO favors mortgage-backed securities (MBS), investment-grade issuers with stable and predictable cash flows, and “high-quality securitized credit”;

PIMCO recommends staying cautious about “direct loans and bank loans with weak covenant terms, lower-quality high-yield bond issuers, and many special-purpose vehicle structures where liquidity does not match the underlying assets.”

(China Finance Network, Xiaoxiang)