Traders see growing chance of Fed rate hike in May, pause or cuts thereafter

After an expected move of similar size in the past two days, traders are increasing their odds of a quarter point rate increase in May.

This suggests that policymakers will not ignore recent banking sector pressures and raise rates twice more. Fed-funds futures trading showed that the odds of a quarter point hike at this week’s Fed policy meeting rose to 73.1% Monday, from 62% Friday. The likelihood of another such move in May rose 38.2%, from 20.7% previously. Morning trading also saw a jump in TMUBMUSD01M for 1-month, 4.251%, and TMUBMUSD03M for 3-months, 4.601%.

Investors have been struggling with two competing theories, which Joe Kalish of Ned Davis Research described as the 'cockroach theory' versus the idea that lightning-never-strikes-the-same-place twice.

He wrote that the first theory is about the idea that there's 'never just one cockroach'. This suggests that the problems facing the banking sector may not be limited to a few banks.

The second theory is that the current turmoil at banks appears meaningfully different from the 2008 financial crisis. This was more about how to value opaque assets. He said that the current conditions boil down to a liquidity issue, which could also be caused by more depositors withdrawing their money from banks.

Wall Street is split over what will happen next. While David Mericle, Goldman Sachs GS +1.81%, expects that the Fed will pause on Wednesday's, BofA Securities' Mark Cabana and Michael Gapen are predicting a 'jittery 25-basis point hike. BofA's team sees the Fed ending its rate-hike campaign at 5.25% to 5.5%, compared to the current 4.5% to 4.75%.

The chart shows how quickly overnight indexed swaps have been repriced after the emergence of banking system risks. These swaps reflect a slight increase in the fed-funds target rate, but this will be offset by rate cuts for the rest of 2023.

On Monday morning, Treasury yields were generally higher than before risk aversion. The U.S. stock market indexes DJIA (+0.81% SPX), +0.42% COMP and -0.24% were mixed going into afternoon trading.