A surprise Fed move? Markets are keeping the door open

• Dow up >1%, S&P 500, Nasdaq modestly green
• Staples lead S&P 500 sector gainers; Energy weakest group
• Euro STOXX 600 index up ~0.4%
• Dollar down; gold off ~1%; bitcoin down >1%; U.S. crude falls ~4%
• U.S. 10-year Treasury yield falls to ~4.59%

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Markets are increasingly focused on the possibility of a surprise Fed move this week. Fed funds futures have pushed the odds of a rate hike toward 40%, although prediction markets remain closer to 20%. Notably, according to Ben Emons, founder of FedWatch Advisors, prediction markets have built an impressive recent track record, correctly signaling the outcome of each of the last five FOMC decisions.

Even so, Emons argues in a note out late Monday that the fact that both futures and prediction markets are assigning meaningful odds to a hike suggests investors view this meeting as an important checkpoint for the Fed, especially given continued uncertainty surrounding the inflation outlook.

Beyond this week, markets are also debating how much further the Fed may eventually have to tighten. While the 2-year Treasury yield remains well above the current Fed funds rate, Emons notes that prediction markets are assigning high odds to multiple rate hikes into 2027. In other words, investors increasingly believe the Fed's next move is more likely to be up than down.

The debate largely comes down to real interest rates and inflation. Short-term real yields remain relatively modest given inflation above 3%, suggesting policymakers may need to reverse some of last year's easing. At the same time, longer-term real yields have climbed back toward pre-financial-crisis levels, reflecting expectations for stronger economic growth and a higher neutral rate.