Bond market volatility tightens financial conditions ahead of Fed rate hikes

The global bond market is experiencing significant volatility, with the MOVE index rising by 34 basis points over the past month. This has pushed the RSM US Financial Conditions Index back to neutral, indicating that U.S. financial conditions are now largely supported by equity valuations. The index stands at 0.6 standard deviations above neutral, suggesting only a moderate level of accommodation remains in the financial markets.

The Federal Reserve is closely monitoring these conditions, which supports the expectation of one more rate hike this year, a 25 basis point increase in December. However, if longer-term yields continue to rise, another hike in March 2027 could be on the table, though current market pricing via overnight index swaps supports the baseline forecast.

Financial conditions are tightening, with money market rates exceeding 3.90% and the bond market selloff intensifying. The S&P 500 has also lost ground since late August. The bond market is under the most stress, with volatility spiking above its one-year and five-year averages, driven by rising global interest rates amid inflation concerns and deteriorating fiscal balances.

The money market has already adjusted to the Fed’s tightening, with the effective overnight federal funds rate now at 3.88%. Futures and overnight index swap markets are pricing in a December rate hike followed by another in March. The Secured Overnight Financing Rate has tested 3.90% over the past week, while the OIS rate trades at 4.0%. Lenders are expected to demand higher returns to offset potential losses from further rate increases.