Fears of inflation from surging oil prices are mounting again as armed conflict between the United States and Iran intensifies. In response, market expectations that the Federal Open Market Committee (FOMC) will raise interest rates at its meeting scheduled for the 28th have tripled. While a hold remains more likely, volatility has increased, reflecting the view that a hike could materialize at the September FOMC.
Investors have moved quickly. With the yield on the U.S. 10-year Treasury note hitting its highest level in a year and a half, a growing number of investors are selling off blue-chip bonds and choosing high-risk, high-yield bonds.
Rate-Hike Odds Triple on FedWatch
On the 25th, the Financial Times (FT) reported, based on the Chicago Mercantile Exchange's (CME) FedWatch data, that the probability of the Fed raising rates by 0.25 percentage point at its meeting on the 28th had risen to 38%, nearly triple the level of a week earlier (13%). The FT assessed that this "means Fed Chair Kevin Warsh is under strong pressure to show he is prepared to control a new shock to inflation."
The move comes as oil prices surged, with the war between the United States and Iran flaring up again and the Bab-el-Mandeb Strait in the Red Sea at risk of being blockaded. On the 23rd, the closing price of September-delivery Brent crude futures on the ICE Futures exchange was $100.69 per barrel, up 7.04% from the previous session. On the New York Mercantile Exchange, the closing price of September-delivery West Texas Intermediate (WTI) crude futures also rose 6.17% from the previous session to $92.19 per barrel. Both crude grades extended their gains for a fifth consecutive trading day. Brent crude was at its highest level since May 22, and WTI since June 4. Goldman Sachs forecast that Brent crude could exceed $120 per barrel in the fourth quarter if disruptions to the Bab-el-Mandeb Strait persist.
Hawks vs. Doves: "Still 50-50"
As recently as early this month, the market saw a much higher probability of a rate hold. Expectations for oil price stability had grown after the United States and Iran signed a memorandum of understanding (MOU) to end the war. The June U.S. Consumer Price Index (CPI) also eased inflation concerns, falling by the largest margin in six years. The June U.S. CPI rose 3.5% from the same period a year earlier, sharply slower than in May (4.2%). It also came in below the expert estimate compiled by Dow Jones (3.8%). On a month-on-month basis, it fell 0.4%, a larger decline than the market estimate (-0.2%). The month-on-month drop was the largest in six years since April 2020 (-0.8%), during the early stage of the COVID-19 pandemic. According to the Wall Street Journal (WSJ), before the CPI release, the interest rate futures market priced in about a 40% probability that the Fed would raise rates at the end of the month, but immediately after the release, this probability fell to about 15%. However, on the oil price surge, the probability of a rate hike jumped back to its previous level.
Chair Warsh has also emphasized the principle of making price stability the top priority. Appearing at a hearing of the U.S. House Financial Services Committee on the 14th, he stressed, "My fellow committee members and I recognize that high inflation has placed an excessive burden on American households and businesses," adding, "Our committee members share a firm commitment not to tolerate persistently high levels of inflation and to restore price stability."
However, experts analyzed that hawks and doves within the Fed remain evenly balanced. Mark Cabana, head of U.S. rates strategy at Bank of America (BOA), said, "The July Fed FOMC meeting is a live variable," adding, "It is highly questionable whether current monetary policy is restrictive." Robert Sokin, chief U.S. economist at asset manager PGIM, also described it as "effectively a 50-50 fight."
Investor Sentiment Shifts on Rate-Hike Fears: Selling Blue-Chip, Moving to High Yield
As the probability of a rate hike rose on inflation fears driven by rising oil prices, U.S. Treasury yields soared while investors dumped fixed-rate corporate bonds en masse.
On the 25th, Reuters reported, citing Lipper, the world's largest fund data analytics firm under the London Stock Exchange Group (LSEG), that $8.2 billion (about 12 trillion won) flowed out of U.S. investment-grade (IG) bond funds in a single day on the 20th, marking a record high. Weekly net outflows also hit a record $7.1 billion in total.
Reuters explained that "safe investment-grade bonds have lower coupon rates (interest rates) and longer maturities than high-interest, high-risk bonds, making them sensitive to the possibility of rising market rates." U.S. Treasuries also saw continued selling, with the 10-year Treasury yield climbing above the 4.7% line on the 23rd. This was the highest level in about a year and a half since January 2025.
By contrast, high-risk, high-yield bond funds saw inflows of about $534 million (about 781.3 billion won), and leveraged loan funds also recorded slight inflows. Leveraged loans carry floating rates, so investors can expect higher returns during a period of rate hikes. In fact, LQD, a representative blue-chip corporate bond ETF, has seen its price fall 2.58% this month, while high-yield bond ETFs limited their decline to just 0.93%, defending against losses far better.
