Fed will hike rates by 75 basis points in June and July - Nomura

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Seventy-five basis points is the new 50 basis points.

A relentlessly hawkish Federal Reserve is ramping up market expectations for big interest rate hikes that would've been considered unthinkable (and market crippling) just two months ago.

Nomura said Friday that the FOMC will hike the fed funds rate by 75 basis points in June and July after a 50-basis point rise in May. That would bring the rate up to 2.25%, a phenomenal amount of tightening given that the Fed was still easing by buying assets as recently as March.

The shift in market expectations for even more tightening came after Fed Chairman Jerome Powell said at an IMF debate Thursday that a 50-basis-point hike in May was "on the table." Perhaps even more pertinent to the markets, he said there was some merit in front-loading tightening with the upside risks to inflation and a historically tight labor market.

Traders quickly priced in more aggressive hiking as Powell spoke, with CME FedWatch now pricing in an 85% chance the benchmark rate will rise to a range of 1.5%-1.75% after the June meeting. That would mean a 75-basis point hike in June if May gets the expected half-point boost.

Chatter of a hike of as much as 75 basis points started last week when St. Louis Fed President James Bullard said that he wouldn't rule one out.

Before Powell spoke yesterday, San Francisco President Mary Daly added some fuel to the fire, saying she would be talking to colleagues about whether a hike of 25, 50 or 75 basis points was needed.

In fed funds futures, the market is now pricing in about 270 basis points of tightening for 2022, topping 250 seen in 1994, with expectations now for the rate to hit 3% by March 2023, according to Deutsche Bank.

Deutsche Bank's chief economist said yesterday that the Fed could hike rates to as high as 5% by the time it's done tightening, a level not seen since 2006.

Quotes: “Our U.S. team has changed their Fed call,” Rob Subbaraman, Nomura head of global markets research, wrote in an email seen by Bloomberg. “They now expect the FOMC to be even more front-loaded with rate hikes, in order to get the funds rate back to neutral as expeditiously as possible to avoid a wage-price spiral.”

“We recognize Fedspeak has not outright endorsed a 75 basis point hike yet, but in this high inflation regime we believe the nature of Fed forward guidance has changed - it has become more data dependent and nimble,” he said.

"We are in a new environment, dancing to a new tune, and the incremental mean reversing way of thinking about inflation and rates is likely to be misleading," Deutsche Bank chief economist David Folkerts-Landau said. "Inflation is seeping into expectations, and labor markets are historically tight."

What this means for stocks and bonds: The selloff in Treasury bonds accelerated as expectations for even more hawkish policy rose.

The 10-year Treasury yield (NYSEARCA:TBT) (TLT) hit 2.95% at the high of the day Thursday and is back up at that level this morning. The 2s10s curve flattened and the 2-year yield (SHY) is up 7 basis points to 2.76% in early trading today.

Stocks started Thursday with a rally, but the big rise in rates (especially real rates) reversed the trend and the S&P (SP500) (NYSEARCA:SPY) fell 1.5%, while the Nasdaq 100 (NDX) (QQQ) lost 2%.

Worries will increase in the equities market if the Fed slams on the brakes as Nomura predicts.

Investors "are in a new investing world," eToro strategist Ben Laidler said. "The sharp and never-ending repricing of Fed interest expectations and high-for-longer inflation has driven bond volatility twice that of equities, and a tightening US financial conditions index."

"This drives lower valuation and a Growth to Value rotation," he added. "Equities are being stress-tested by surging bond yields. But there is a limit to how high yields will go. The Fed has more yield control now with its huge balance sheet runoff, whilst high debt levels, and wide yield gap with global markets are constraints."

BofA said stock bulls are now an "endangered species," but that is a contrarian bullish signal.