Traders expect higher interest rates to stay for foreseeable future
4 min read . Updated: 01 Nov 2022, 05:42 PM IST 
PremiumWagers on rates remaining higher for longer are now nearing their highest levels since 2013
Ahead of the Federal Reserve’s next decision on Wednesday, derivatives markets show the federal-funds rate sitting at around 3.5% for the long run. That is a full percentage point higher than the central bank’s own latest forecast. Those wagers have crept higher throughout most of the year, and are now nearing levels not seen since the 2013 bond-market rout known as the “Taper Tantrum."
A long period of higher rates could upend markets, which have been rebounding in recent weeks. Higher rates have punished once-highflying tech stocks this year, which had reaped the benefits of near-zero borrowing costs. A longer-term transition to higher rates could mean weaker valuations for the tech sector, along with others where investors expect profits further down the road.
The market bearing these interest-rate bets—the five-year, five-year overnight indexed swap rate—is set by market participants either hedging interest rate exposure or betting on where the fed-funds rate will be over the five-year period starting in five years, making it a useful gauge for the future path of Fed policy.
The swap rate has surged from below 1% in early 2020 to its highest levels since 2014, around the end of investors’ multimonth bond-selling spree that followed the central bank’s announcement that it would pull back from financial crisis-era bond-buying programs.
The last time the Fed attempted to reinitiate those efforts in 2017, trouble in short-term lending markets forced officials to inject emergency cash just two years later. With the central bank now diving into another round of those efforts, traders are reupping their wagers.
Most investors expect Fed officials to lift the benchmark federal-funds rate by 0.75 percentage point at the central bank’s November meeting, which would be the fourth consecutive raise of that size.
The yield on the 10-year Treasury has risen to about 4% from just 1.6% in January, helping pull down the benchmark Bloomberg U.S. Aggregate bond index by over 15% on the year. The 10-year yield is up over 1.4 percentage points since August, its largest three-month gain since 1984.
Many investors keep hoping for central banks to slow inflation-fighting efforts. After the European Central Bank lifted rates by 0.75 percentage point at its latest meeting—and several officials expressed desire for a less aggressive move—bond and futures markets quickly adjusted for a slower pace of tightening. Those moves reversed, however, after several European nations reported stubbornly high inflation and policy makers pushed back against the idea that easing was on the table.
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Futures contracts tied to the policy rate now show fed funds peaking at about 5% around May or June, and remaining lofty from there. Earlier in the year, traders had centered around the idea that rates would peak in March, to be followed by significant rate cuts.
Smaller rate increases from the Fed might not actually mark a pivot in policy, said Nomura managing director Charlie McElligott in a Monday note. The more important shift is “a lengthening-out of the hiking horizon," he wrote.
Major drivers of the renewed tight monetary policy expectations include the unusual strength of household finances, bolstered by pandemic-driven stimulus. A historically hot labor market also fuels inflation through wage-increases. With little signs of economic or financial unease, the Fed might have more room to run.
“If nothing is going to break in the financial markets, it’s going to take some time to generate enough destruction in the employment landscape to bring down consumer demand," said Bryan Whalen, co-chief investment officer of fixed income at TCW.
A recent survey from the New York Fed showed Americans’ median inflation expectations over the next year are continuing to fall, but longer-term expectations for the next three years ticked higher to 2.9%. The latest consumer survey from the University of Michigan showed similar expected price changes, but over the next five to 10 years.
Swap contracts tied to the consumer-price index don’t show headline inflation breaking below 2.6% at any time over the next 30 years. Those bets have vastly undershot actual inflation rates this year.
“Unless the Federal Reserve is willing to engineer a depression, we are going to have to deal with inflation for at least two-to-three more [tightening] cycles," said Thomas Tzitzouris, managing director and head of fixed income research at Strategas. “Rate increases will crush economically sensitive cyclical inflation, but 3% to 4% headline inflation is structural."