Author: Li Jia
Under the dual impact of rising oil prices and the absence of forward guidance from the Federal Reserve, markets have begun repricing policy risks.
While mainstream economists unanimously expect the Fed to hold rates steady next week, the implied probability of a rate hike from interest rate markets has risen to about 30%, pushing U.S. Treasury yields higher across the curve. The yield on the two-year Treasury note hit a new high since early 2025, the benchmark 10-year yield rose to its highest level this year, and the 30-year yield approached its highest level since 2007.
A Citi research report released on July 23 suggests that this market pricing does not mean investors are widely betting on an imminent Fed rate hike, but rather reflects investors demanding higher risk premiums to hedge against policy surprises in an environment where forward guidance has become more ambiguous and oil prices are elevating inflation risks.
Rising Treasury Yields, Market Prices in ~30% Hike Probability
Recently, escalating tensions in the Middle East have driven a sustained rise in international oil prices, rekindling market concerns about a resurgence of inflation and consequently pushing U.S. Treasury yields higher.
On Thursday, the yield on the policy-sensitive two-year Treasury note rose to around 4.365%; the benchmark 10-year yield simultaneously set a new yearly high; and the 30-year yield climbed to 5.19%, just a step away from its highest level since 2007.
Meanwhile, interest rate futures show an implied probability of about 30% for a Fed rate hike at next week's meeting. However, this pricing deviates significantly from mainstream expectations. A Bloomberg survey shows that none of the 70 economists polled expect the Fed to raise rates next week.
Citi: The 30% is Not a Market Forecast, But a Risk Premium
Citi offers a different interpretation of this seemingly contradictory phenomenon.
Citi economists Andrew Hollenhorst, Veronica Clark, and Gisela Young point out that the 30% in market pricing does not mean investors genuinely believe the Fed has a three-in-ten chance of hiking; it incorporates an additional risk premium.
The report argues that since a rate cut is almost impossible at next week's meeting, policy risk is inherently skewed to one side. If the Fed were to surprise with a hike, the bond market would suffer a far greater shock than if it remained on hold. Therefore, investors are willing to pay an extra cost to price in this tail risk in advance.
Citi notes that historically, the risk premium associated with Fed meetings was typically only 1 to 2 basis points. However, as the Fed has reduced forward guidance in recent years and policy communication has become more data-dependent, uncertainty has increased, and the risk compensation demanded by the market has expanded accordingly.
This logic also explains the current movement in long-term rates. Citi believes that if a future meeting were to unexpectedly result in a rate hike, the market would likely interpret it as the start of a new rate-hiking cycle rather than an isolated event, thus lifting terminal rate expectations as well. For this reason, the market is currently pricing in more than 50 basis points of cumulative hikes by March of next year, but this does not mean it represents investors' base-case scenario.
Citi: The More Ambiguous the Guidance, the Easier for Rates to Stay High
Citi argues that the recent rise in oil prices is merely a catalyst prompting the market to reassess the policy path; the deeper reason lies in changes to the Fed's communication framework.
The report points out that Middle East tensions have pushed up oil and U.S. gasoline prices, strengthening market concerns about the risk of inflation reaccelerating. With Fed officials not providing clear policy guidance, this uncertainty has further amplified market anxiety about policy surprises.
Citi emphasizes that during periods of clear forward guidance, market risk premiums were typically negligible. However, currently, each policy meeting carries greater policy uncertainty, and investors need to pay a risk premium in advance for potential surprises.
This means that even if the Fed ultimately holds rates steady, Treasury yields may not necessarily retreat significantly as hike expectations fade. Citi believes that until the Fed re-establishes a clearer communication framework, the phenomenon of risk premiums pushing up interest rates may persist.
