: Robust U.S. jobs data opens door to outside risk of full percentage point rate hike by Fed this month

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Following an unexpectedly robust jobs report that had many dismissing fears of a U.S. recession, a line of thinking re-emerged in some parts of the financial market on Friday as investors turn to next week’s June consumer price index report.

Traders in federal funds futures now see a 7% chance that the Federal Reserve could deliver a 100-basis-point, or full-percentage-point, rate hike in three weeks; that’s up from a zero-percent chance seen throughout the past month, according to the CME FedWatch Tool. Strategists said the market is comfortable pricing in a “nonzero” chance of a rate hike of greater than 75 basis points on July 27, even as Friday’s jobs report seemed to cement a three-quarters-of-a-percentage-point hike.

Before Friday’s data, strategists had already been contemplating a scenario in which financial markets could begin seeing a higher likelihood that inflation comes unanchored and stays higher for longer — both of which would likely force the Fed to hike more aggressively than it already has. This scenario hasn’t played out yet, though: 5-, 10- and 30-year breakeven rates are trending below 2.6% as of Friday, according to Tradeweb data, reflecting the market’s view that inflation should return to normal-looking levels in the long run. And most forecasts still see inflation subsiding at some point.

Also see: Every rose has its thorn: Strong U.S. jobs report contains a few troubling signs

But inflation has proven to be a dynamic force. It has confounded widespread expectations that it would ease over the past year, and forced Fed officials to suddenly increase the size of their last rate hike in June, to 75 basis points versus a prior expectation of 50 basis points. The possibility of a 100-basis-point hike has been floating around some pockets of the market since last month. But June’s better-than-expected gain of 372,000 new jobs seemed to give a touch of credence to that outside risk again on Friday.

Inflation-derivatives traders are bracing for next Wednesday’s annual headline CPI rate to come in at 8.9% for June, up from 8.6% for May and followed by three additional 8%-plus readings in July, August and September. Based on those views, BofA Securities interest-rate strategist Bruno Braizinha told MarketWatch in an email earlier this week there’s a risk “that the market starts to assign a higher probability of an un-anchoring of inflation.”

Read: ‘Inflation is going to be stickier than most people imagine’: Inside the obscure market where traders have been mostly right about price gains.

If that happens, it may mean two things, either of which would lead to the potential for “100 [basis point] moves in rates,” he wrote on Wednesday, before Friday’s jobs report was released.

One is that the Fed, in order to stay credible, starts to target real or inflation-adjusted policy rates in the near term, the strategist said. That’s significant because “if inflation is going to run at an average of 4% over the next two years,” then the Fed “only starts to be in restrictive territory and pushing back effectively against inflation once it reaches 4.5% for the fed funds rate or above.”

Until now, policy makers have been speaking about the fed funds rate in terms of a nominal level and considering a fed funds rate of roughly 2.5% as a level that neither stimulates nor restrains growth, Braizinha said. Going above 2.5% was seen as being “in restrictive territory and pushing back effectively against inflation pressures,” he said. However, “it is easier to speak of the nominal neutral rate when inflation is well behaved around 2%, then when inflation is running at 7% [or] 8%.”

The implications of a shift to targeting inflation-adjusted policy rates, if that scenario pans out, would be “huge” for the markets, Braizinha wrote. “The curve bear flattens aggressively and inverts more deeply at the peak of the tightening cycle. Recession probabilities are frontloaded, and that contributes to some anchoring of back-end yields. Volatility continues to stay elevated, and pain in risky assets more significant.”

The second scenario Braizinha envisions, but believes less strongly in, he said, is one in which the market shifts into a higher-for-longer view on long-term inflation. That, too, would entail the neutral level of the fed funds rate moving higher, “from the current 2.5% to the mid-3% range.”

“The implications of this scenario for the markets are quite significant also,” he said. “A higher neutral rate view pushes yields at the back end of the curve higher. If the neutral rate goes to mid-3%, then you should expect peak [10-year Treasury] rates in the cycle around 4% or slightly higher.” In addition, “the forwards on the curve are likely to stay steeper” and volatility is “likely to stay supported in this context.”

“These are not part of our core scenario for rates, but are [a] tail risk that we recommend our clients to hedge,” he wrote. In either of the two scenarios, “we are talking about potential for 100 [basis point] moves in rates.” 

On Friday, investors aggressively sold off Treasurys after the jobs report, sending yields higher across the board with the 10-year rate TMUBMUSD10Y, 3.084% at 3.1%.

This article was originally published by Marketwatch.com. Read the original article here.

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