Markets price Fed hike as oil exceeds $100

Wall Street is preparing for the Federal Reserve to raise interest rates this week for the first time since July 2023, after another surge in oil prices and stubborn inflation pushed market expectations decisively towards tighter policy.

Interest-rate futures on Monday assigned roughly a 90% probability to a quarter-point increase at the Federal Open Market Committee’s September 15-16 meeting. A move of 25 basis points would lift the federal funds target range to 3.75%-4.00%, reversing expectations held only weeks ago that policymakers would keep rates unchanged through the year. That prospect has reshaped positioning across stocks, bonds and currencies.

The shift has intensified pressure across financial markets. Brent crude traded above $107 a barrel and West Texas Intermediate above $102 as investors assessed fresh threats to Middle East energy supplies. The rise in fuel costs has reinforced concerns that inflation could remain above the Fed’s 2% target, complicating efforts to stabilise prices without damaging growth.

US Treasury yields reflected the change in policy expectations. The benchmark 10-year yield briefly moved above 5% on Monday, reaching levels not seen since 2023 on a closing basis and touching its highest intraday territory in years before easing. Higher long-term yields threaten to raise mortgage, corporate and consumer borrowing costs while reducing the relative attraction of equities.

Stocks consequently entered the Fed week under pressure. Major US indices weakened as investors weighed expensive financing, elevated energy prices and uncertainty over how aggressively the central bank may tighten after Wednesday. Technology shares were particularly sensitive to higher bond yields because much of their valuation rests on profits expected further into the future.

The policy repricing followed stronger inflation readings for August. The consumer price index rose 0.4% from the previous month and 3.4% from a year earlier, while underlying measures also showed persistent price pressure. Those figures, combined with resilient economic activity, reduced confidence that inflation was moving steadily enough towards the Fed’s objective.

Economists have also shifted sharply. A large majority now expect a quarter-point increase this week, with several major banks reversing earlier calls for no change. Some forecasters expect at least one additional increase over the coming months if inflation remains elevated, although the path will depend heavily on energy prices, labour-market conditions and incoming price data.

Oil has become the immediate market complication. Saudi Arabia temporarily shut its East-West pipeline after an attack, restricting a route that allows crude to bypass the Strait of Hormuz. Shipping traffic through Hormuz has also remained below normal levels amid wider regional tensions, increasing concerns over the security of supplies from the Gulf.

Brent climbed as high as around $108 a barrel during Monday trading before paring part of the advance. WTI also remained above $100, levels that can quickly filter into transport and production costs. The energy shock is particularly awkward for monetary policymakers because higher rates cannot directly repair disrupted oil supply, even as they may be used to prevent higher fuel prices from feeding broader inflation expectations.

Bond investors are divided over the appropriate response. Some argue that a rate rise would reinforce the Fed’s commitment to restoring price stability and could ultimately help contain long-term yields by anchoring inflation expectations. Others say further tightening risks unnecessary damage to housing and other rate-sensitive sectors while doing little to address a supply-driven increase in energy costs.

The Fed’s communication on Wednesday may therefore prove as important as the decision itself. Investors will scrutinise Chair Kevin Warsh’s remarks and updated policy projections for clues on whether an increase is intended as a limited adjustment or the start of a more sustained tightening cycle.

The dollar strengthened on Monday as higher US yields and geopolitical uncertainty increased demand for the currency. The euro and sterling weakened, while the yen also lost ground ahead of separate central-bank decisions in Japan and Britain.