Fed rate hike bets surge as oil tops $100 ahead of this week's FOMC meeting

Ahead of Federal Reserve Chair Kevin Warsh's second Federal Open Market Committee (FOMC) meeting on Wednesday, expectations for a rate hike are rising. Over the past two weeks, the United States and Iran have resumed airstrikes, causing markets to lose much of their confidence in a ceasefire agreement — and the resulting surge in oil prices is fueling bets on a rate increase.

According to the Financial Times, as recently as July 17, futures traders put the probability of a Fed rate hike at just 12.8%. But after the US and Iran resumed airstrikes and oil prices broke through $100 per barrel for the first time since May on July 23, the probability of a rate hike climbed to 37.4% by July 24. Futures markets have fully priced in a hike by September, and some forecasts now call for one or even two quarter-point increases over the next nine months.

Since then, reports of back-channel talks between Washington and Tehran and a temporary halt to airstrikes have nudged rate-hike expectations back down slightly to 36.3%. The episode illustrates how quickly market concerns over oil prices and inflation can materialize depending on the state of the US-Iran conflict.

The sudden surge in rate-hike expectations began last week as oil prices spiked. Global investors sold government bonds, sending bond prices sharply lower. The yield on the benchmark 10-year US Treasury note hit its highest level in 18 months, while 10-year yields in Germany and France reached 15-year highs. Long-term bond yields typically rise alongside inflation expectations, and the sharp move higher signals that more investors are bracing for inflation.

Adding to the case for a rate hike, the US labor market remains stable even as inflation has persistently run above the Fed's 2 percent target. Weekly initial jobless claims released July 23 fell to their lowest level since 1969. Meanwhile, last month's consumer price inflation eased to 3.5 percent, but still far exceeds the Fed's 2 percent goal.

Chair Warsh said at a House Financial Services Committee hearing on July 14 that he would have "no tolerance" for persistently high inflation, but offered no hints about the policy path ahead. The Financial Times noted, however, that the Fed's preferred PCE inflation gauge stood at 4.1 percent in May — more than double the 2 percent target.

Mark Cabana, head of US interest rate strategy at Bank of America, told the Financial Times that "the July Fed meeting is clearly live," adding, "It is very much in question whether current monetary policy is restrictive, and oil prices are now rising again." Robert Tipp, chief US economist at asset manager PGIM, described this month's FOMC meeting as "almost a 50-50 call."

Beyond the impact of the renewed conflict and higher oil prices, some analysts said inflation faces additional upward pressure from the AI boom and other factors. Edward Al-Hussainy, a portfolio manager at Columbia Threadneedle, told the Financial Times that "inflation has gotten hotter for reasons that have little to do with oil," citing "some pass-through from tariffs, demand in the system from AI, and a lump of services inflation that hasn't been wrung out of the system over the past few years."