Is there a 30% chance the Federal Reserve will raise interest rates next week?

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Under the dual impact of rising oil prices and the absence of forward guidance from the Federal Reserve, the market has begun to reprice policy risks.

Although mainstream economists unanimously expect the Federal Reserve to hold steady next week, the probability of a rate hike implied by the interest rate market has risen to about 30%, pushing U.S. Treasury yields higher across the curve. Among them, the yield on the 2-year U.S. Treasury note hit its highest level since early 2025, the 10-year yield rose to a yearly high, and the 30-year yield approached its highest point since 2007.

A research report released by Citi on July 23 believes that this market pricing does not mean that investors are broadly betting on an imminent Fed rate hike, but rather reflects more that, in the context of increasingly vague forward guidance and higher inflation risk driven by oil prices, investors are demanding a higher risk premium to cope with policy surprises.

U.S. Treasury yields rise, market prices in about 30% rate hike probability

Recently, escalating tensions in the Middle East have driven international oil prices steadily higher, reigniting market concerns about inflation making a comeback, resulting in continued rises in U.S. Treasury yields.

On Thursday, the yield on the 2-year U.S. Treasury note, which is most sensitive to monetary policy, rose to about 4.365%; the benchmark 10-year U.S. Treasury yield also hit a new high for the year; the 30-year U.S. Treasury yield rose to 5.19%, just shy of its highest point since 2007.

Meanwhile, interest rate futures indicate that the Fed's meeting next week already implies about a 30% chance of a rate hike. However, this pricing is significantly at odds with mainstream expectations. A Bloomberg survey shows that among 70 economists surveyed, none expects the Fed to raise rates next week.

Citi: The 30% is not a market forecast, but a risk premium

For this seemingly contradictory phenomenon, Citi offers a different explanation.

Citi economists Andrew Hollenhorst, Veronica Clark, and Gisela Young point out that the 30% in market pricing does not mean investors truly believe there is a 30% chance of a Fed rate hike, but rather includes an additional risk premium.

The report argues that, since there is virtually no chance of a rate cut at next week's meeting, policy risk is naturally skewed to one side. If the Fed surprises with a rate hike, the impact on the bond market will be much greater than if it stands pat, so investors are willing to pay extra to price in this tail risk in advance.

Citi notes that, historically, the risk premium associated with Fed meetings is usually only 1 to 2 basis points, but as the Fed has reduced forward guidance in recent years and policy communications have become more data-dependent, uncertainty has increased, and the risk compensation demanded by the market has also grown.

This logic can also explain the current movement of long-end rates. Citi believes that, if there really is a surprise rate hike at an upcoming meeting, the market is likely to see it as the start of a new tightening cycle rather than an isolated event, so terminal rate expectations will also be raised accordingly. For this reason, the market has currently priced in more than 50 basis points of cumulative hikes by March next year, but this does not mean this is investors' baseline scenario.

Citi: The more vague the forward guidance, the easier it is for rates to stay high

Citi believes that the recent rise in oil prices is only a catalyst for the market to re-evaluate the policy path, while the deeper reason lies in the changes in the Fed's communication framework.

The report points out that Middle East tensions have driven up oil and U.S. gasoline prices, heightening market concerns about renewed inflation risk. In the absence of clear policy guidance from Fed officials, this uncertainty further amplifies market concern over policy surprises.

Citi emphasizes that when forward guidance is clear, market risk premium can usually be ignored; but now, each policy meeting carries greater policy uncertainty, and investors need to pay risk compensation in advance for potential surprises.

This means that even if the Fed ultimately stands pat, U.S. Treasury yields might not significantly fall just because rate hike expectations fade. Citi believes that unless the Fed re-establishes a clearer communication framework, the phenomenon of higher rates driven by risk premium may continue to exist.

Risk Warning and DisclaimerThe market involves risk, and investment should be made cautiously. This article does not constitute personal investment advice and does not take into account any individual's particular investment objectives, financial situation or needs. Users should consider whether any opinions, views or conclusions in this article are suitable for their particular situations. Investment based on this information is at your own risk. ```