What if the Fed U-Turns and Raises Rates This Year?

This isn’t just a matter of whether the economy stays hot or whether the new Trump administration’s tariff, immigration and tax policies prove inflationary, though both matter. At the heart of it for investors is an important question: Are the barriers to raising rates stiffer than those to cutting? Or put another way, will the Fed need more evidence to hike than it needs to cut?

History shows that the Fed likes to signal big changes far in advance, and takes time to be sure it is right before starting to raise rates.

Since it started releasing postmeeting policy statements in 1994, the Fed has only once switched from cuts to hikes in less than a year. That one time was special: It slashed rates in late 1998 because the failure of Long-Term Capital Management threatened to bring down Wall Street, and once it was obvious everything would be fine, it began raising rates again. Even then, it took seven months to change course, despite the rapid inflation of the dot-com bubble.

Still, some think the Fed has learned from its initially lackluster response to the inflation shock of 2021-22, and will move quickly if there is a threat of a resurgence.

“They’re not going to hint at hikes until there is a lot more data,” says Ed Al-Hussainy, global interest-rate strategist at Columbia Threadneedle Investments. “But it’s a paper barrier, and they will break through it quickly if the data becomes overwhelming.”

Investors who think there is more of a barrier to rate rises might consider buying short-dated Treasurys, maturing in one year, or perhaps two. The simplistic idea is that it is a win-win: If things go well in the economy, the Fed will resist or delay rate rises, so nothing much changes and you collect the yield. If things go badly, the Fed will cut and the price of the Treasury rise.

The trade could also be shifted to a later maturity, say five years, and still maintain some link to Fed rates, with more potential for gain. Unfortunately, it also brings more potential for loss, as it adds some of the risks that come with longer-dated bonds, such as the Treasury financing with more bonds and fewer bills, worries about the budget deficit or a shift to permanently higher rates.

The markets rarely hand out free money, and the idea naturally comes with drawbacks. The big risk is that it is just wrong, and the Fed raises rates. More insidious, and more likely in my view, is that the Fed stays on hold but traders start to prepare for higher rates, selling Treasurys, as they have recently with longer-dated bonds.

It would be easy for investors to price in a more hawkish Fed. At the moment, there is one more cut priced in, so even without expecting the Fed to raise rates the market could move to higher Treasury yields just by removing that one cut—albeit on a one-year or two-year maturity that wouldn’t create a large loss.

Gregory Peters, co-CIO at PGIM Fixed Income, says the market is already pricing some of the asymmetry, but with huge volatility. “I think the consensus [is] that the skew [between chance of cut or chance of hikes] works in your favor,” he says. “But we’re traversing a very wide range here.”

In just the past eight months, the 2-year yield has dropped from 5% to 3.5% then risen back to 4.4%. An investor who bought the 2-year at 3.5% in September is fractionally down even after including the income from the coupon.

Early signs of the possibility of a rise are showing up in options on the secured overnight financing rate that acts as the benchmark cost of borrowing. Options on SOFR for the end of the year imply a 35% chance of a hike, according to the Atlanta Fed, up from 30% the day after the Fed’s December cut (these options are used to protect against extreme moves, so some probability is normal). But a rise is still far from the expected outcome.

While a rate rise seems unlikely to me, that is also the view of the market. If the Fed did start to talk about hiking, there could be a big market reaction long before any actual Fed hike.

Write to James Mackintosh at james.mackintosh@wsj.com