Middle East Conflict Shatters Rate Cut Dreams! Markets Begin Discussing Rate Hikes Deutsche Bank: Fed Will Avoid Repeating Past Mistakes

Investors originally expected the Federal Reserve to cut interest rates two to three times this year, but now they believe there may not be a single cut. In fact, the market is already discussing the possibility of rate hikes.

According to the CME FedWatch Tool, there is a 74% chance that the federal funds rate will remain at the current 3.5%-3.75% level at the December 2026 meeting. In January, investors only saw a 5% chance of this outcome, when they expected at least a 50% probability of two to three rate cuts.

Meanwhile, traders are increasing their bets on rate hikes by the Fed, expecting a 20 basis point increase by the end of the year. On Monday, the swap market showed a 20 basis point hike this year, up from 8 basis points last Friday, and a week ago, a 25 basis point cut was priced in.

This shift in expectations is mainly driven by soaring oil prices. After attacks by the US and Israel on Iran, Iran effectively blocked the Strait of Hormuz, disrupting global oil supplies and causing oil prices to surge.

On Monday, Brent crude oil prices fell slightly as US President Trump signaled a de-escalation, but since the outbreak of war, prices have still risen over 40%.

This upward trend has pushed up gasoline prices and raised concerns about broader inflation. When the Fed worries that high inflation impacts outweigh the risks of a soft labor market, it tends to adopt a more hawkish stance, and investors are now factoring this into their pricing.

Chicago Fed President Goolsbee hinted at this on Monday. He said that with unemployment remaining relatively stable, inflation is currently the main risk facing the US economy. He also mentioned that “it’s conceivable that the Fed may need to raise rates in some circumstances,” but if the Iran conflict is quickly resolved, the Fed could still cut rates later this year.

This would break one of the main bullish arguments for stocks. Since early last year, investors have been optimistic about rate cuts, as the Fed signaled a dovish stance amid cooling inflation, and lower rates have been a key factor in most Wall Street analysts’ bullish outlooks.

As concerns about rising inflation intensify, the market is now discussing the possibility of rate hikes.

Last week, US Bank stated that “whether the Fed will raise rates this year” has become a question their clients have been asking recently. The bank’s answer is: while the possibility cannot be completely ruled out, three conditions must be met for the Fed to hike rates: a stable labor market, further acceleration of inflation, and Powell remaining as Fed Chair.

Deutsche Bank: The Fed will avoid repeating past mistakes

Although the reasons for not cutting rates recently have strengthened, Deutsche Bank analysts recently offered another reason why investors’ expectations for rate cuts are justified.

In a report to clients on Monday, the bank said that the Fed might look at recent history to guide its decisions and choose a hawkish approach to avoid repeating the inflation surges of 2021 and 2022.

Deutsche Bank pointed out that during the 1979 oil crisis, the Fed adopted more aggressive rate hikes amid rampant inflation than it did in the early 1980s. The bank also noted that during the COVID-19 pandemic, the Fed implemented highly dovish policies, whereas its response to the 2008 financial crisis was less accommodative.

“A key lesson from past crises is that central banks tend to correct the mistakes made during the previous one,” said Henry Allen, Deutsche Bank’s macro strategist, in the report. “Therefore, as we face a new wave of inflation shocks, the central bank wants to avoid being criticized like in 2022, when their response to inflation was too lax. We see this understanding influencing current strategies, meaning that when inflation reaches certain levels, the central bank will issue more hawkish statements.”

At the March Federal Open Market Committee meeting last week, Fed Chair Jerome Powell said the committee would closely monitor how the Iran conflict affects inflation data. He stated, “If we don’t see progress on inflation, you won’t see rate cuts.”

On Monday, President Trump said the US had held “productive” talks with Iran on ending the conflict, so rate expectations could shift in the coming days or weeks. But for now, the Strait of Hormuz remains closed, and the likelihood of rate cuts this year has significantly diminished.

(Source: Caixin)