US Fed’s dual challenge: Will rising inflation and soaring bond yields force Warsh into first rate hike in 3 years?

The US central bank will announce its policy decision on Wednesday, following the conclusion of its two-day meeting. Financial markets are betting heavily that Fed policymakers will raise the benchmark rate by a quarter of a percentage point to a 3.75%-4.00% range and signal further tightening ahead.

The shift in market expectations has been striking. Barely two weeks ago, the CME FedWatch tool showed a 60% chance of a rate hike. Traders are now pricing in a 94.5% chance of a Fed rate hike. If delivered, this will be the first rate hike in over three years.

US Fed’s double whammy

The pressure on the Fed is coming from the bond market as well. The yield on the benchmark 10-year US Treasury note hit 5%, reflecting a range of factors, including expectations that oil prices will remain elevated and that the Fed will raise rates.


For Fed policymakers, Bank of America analysts said the choice is simple: "hike or risk large bond spikes...Trump won't like the choice set but should understand risks of bond un-anchoring and market implications,” according to a Reuters report.

A rate increase, particularly if accompanied by projections for another hike this year as some analysts now expect, could also leave Warsh with little room to avoid offering at least some guidance on the likely path of rates and his own expectations for the economy. Otherwise, the door could remain wide open to further increases.

Inflation keeps Fed under pressure

Morgan Stanley has also joined a growing number of major Wall Street banks taking a more hawkish view on global interest rates. The brokerage is forecasting additional monetary tightening by both the US Federal Reserve and the European Central Bank as inflationary pressures remain persistent, Reuters reported.

According to Reuters, Morgan Stanley expects the Fed to deliver another quarter-point increase in December. The forecast follows recent US inflation data that came in stronger than expected.

Morgan Stanley's revised outlook reflects concerns that the decline in inflation has not been strong or consistent enough to give policymakers confidence that price pressures are moving sustainably towards the Fed's target.

The brokerage now expects two Fed rate hikes this year and sees the central bank signalling the possibility of further tightening before eventually pausing as inflationary pressures ease.

What does it mean for India?

For India, the stakes are significant. US Treasury yields above 5% would make an emerging market such as India relatively less attractive to foreign institutional investors (FIIs), which have already sold more than Rs 14,400 crore of stocks over the past two weeks. FIIs continued to sell even after India attracted record subscriptions to special forex-inflow programmes, which came with regulatory hedging latitude, aimed at boosting reserves and supporting a weakening currency.

“What we’re watching right now goes well beyond a routine wobble in bond markets,” Nigel Green of deVere said. “It’s a major repricing of risk, and it’s happening at a speed that should worry anyone with exposure to stocks, property, or long-duration debt.”

A key factor behind the move is the unusually close relationship between oil prices and US Treasury yields. The one-month correlation between crude prices and the 10-year yield has climbed to 0.96, an exceptionally high reading that reflects how directly energy costs are feeding into inflation expectations.

“Oil and bonds are moving almost in lockstep, and that tells you everything you need to know about where the inflation risk is coming from,” Green said. “When crude climbs, yields climb with it, and that pressure doesn’t stay contained to the bond market. It spreads into mortgage rates, corporate borrowing costs, and eventually into equity valuations.”

Green said a rate hike, instead of the cut many investors had expected for much of the year, would mark a genuine turning point. “A hike here would confirm the inflation fight is far from over,” he said. “Anyone who built a portfolio around the assumption that rates are only moving in one direction from here needs to revisit that assumption immediately.”

A rise in Fed policy rates could push the US 10-year sovereign yield, which is up nearly 7% in a month and now nearing the 5% mark, beyond a threshold considered rather rare this millennium. Investors do not often have to contend with such levels in US bond yields, which have been used to price assets globally for nearly 75 years.

The risks of a decline in equity valuations, particularly in emerging markets like India, are therefore real unless earnings pick up sufficiently to justify the equity risk premium. Higher bond yields could also gradually reduce equity allocations by conservative institutions such as large pension funds, which typically operate with relatively low but steady return mandates. If unusually high risk-free rates are sufficient to meet their return requirements, these investors have less need for exposure to riskier equities, adding further pressure on stocks.

Such a backdrop could ultimately test the resilience of domestic retail investors, who now own about a fifth of Indian equities directly or indirectly and have provided a bulwark against recent bouts of FII selling.

Disclaimer: This article has been written by Veer Sharma, who is not a SEBI-registered Research Analyst or an Investment Adviser. Veer Sharma and his/her ‘relative(s)’ (as defined under Section 2(77) of the Companies Act, 2013) do not hold any financial interest in the companies mentioned in this article as of the date of publication. The views/recommendations mentioned in this article, wherever applicable, are those of the respective SEBI-registered Research Analyst/brokerage and have been reproduced/reported with due attribution. They should not be construed as the views or recommendations of The Economic Times Digital or the journalist. Readers are advised to consider the original research report and make their investment decisions based on their own assessment. Brokerage disclaimershere.