Rising oil prices driven by the US-Iran conflict and US Treasury yields climbing to near two-decade highs have fueled growing market bets on another Federal Reserve rate hike in October. But UBS warns this expectation badly overstates the likelihood of the Fed acting before the midterm elections 鈥?historical data show that since 1990, the Fed has never raised rates at an October meeting close to a November election.
UBS analyst Simon Penn noted in a Monday morning report that the market is currently pricing about a 69% probability of a hike at the October 28 meeting, but he believes this judgment contains a major bias. Penn stressed that while central banks claim their decisions are entirely independent of political activity, refraining from action on the eve of major political events is in fact standard practice. He advised traders to play down October hike expectations and to lower cumulative hike pricing from the current 91 basis points to 75 basis points over the coming year.
Meanwhile, UBS market analyst Nana Antiedu, citing the views of US equity strategist Keith Parker, pointed out that the sharp climb in US Treasury yields has already significantly suppressed equity valuations, but this also means that once yields fall back, there is substantial room for a market rebound.
Historical precedent: no October hike in 35 years
Penn reviewed the historical record since 1990 in his report. Over the past 35 years, there were only three instances in which the Fed raised rates at a September meeting close to a November election 鈥?in 2004, 2018 and 2022 鈥?while a hike at an October meeting has never occurred.
The three September hikes each had their own backdrop: the 2022 hike was the most aggressive, with a single 75 basis point adjustment marking the largest pre-election move in modern history, as the Fed was fully engaged in combating the post-pandemic inflation shock; the 2004 hike was part of the gradual tightening cycle that began in June of that year and ran through the entire election season; and the 2018 hike was pushed through even as the Trump administration publicly pressured the Fed to pause.
In all other election years 鈥?including 1992, 1994, 1996, 2000, 2002, 2006, 2008, 2010, 2012, 2014, 2016, 2020 and 2024 鈥?the Fed took no rate action in either September or October.
Repricing: December should return to a full 25 basis points
Penn argues that removing October hike expectations does not mean the market should reprice the December meeting as a large 50 basis point hike. The market currently prices about 38 basis points cumulatively for December, and he believes this figure should return to a full 25 basis points.
From a trading perspective, the removed October pricing should be shifted and spread across subsequent meetings. Penn expects the January and March meetings to absorb roughly 12 basis points and 18 basis points of pricing respectively. Overall, he advises traders to short the long end and compress cumulative hike pricing over the coming year from the current 91 basis points to 75 basis points.
The yield shock has already hit equity valuations hard
On the equity market side, UBS's analysis is equally noteworthy. Keith Parker pointed out that the sharp rise in US Treasury yields has triggered a significant reset in equity valuations 鈥?since last November, as the 10-year Treasury yield has climbed about 100 basis points year to date, the S&P 500's forward twelve-month price-to-earnings ratio has fallen 17%, a valuation compression approaching recession-scenario levels and comparable to the 1994 tightening cycle.
Historical experience shows that if rates stabilize without substantial tightening (less than 100 basis points of hikes within a year), the S&P 500 typically delivers double-digit returns over the following year; but if a full hiking cycle unfolds (more than 100 basis points within a year), historical equity returns have often been flat or even negative.
Parker believes equities currently have more upside sensitivity to falling yields than downside risk from further yield increases, and advises investors to position for a prolonged period of high rates while capturing the asymmetric opportunity presented by falling yields. On sector allocation, sub-industries such as semiconductors, pharmaceuticals, oil refining and diversified banks score relatively high on composite metrics and have relatively low sensitivity to rates, making them attractive.
Market tug-of-war: energy shock and inflation pressure intertwined
The core contradiction in the current market is that the US-Iran conflict has pushed Brent crude to $106 a barrel, while 10-year and 30-year US Treasury yields have risen to their highest levels since 2007 and 2004 respectively. Whether elevated energy prices will keep inflation sticky and thereby force the Fed to extend its tightening cycle has become the central question for traders.
A series of US economic data due this week will further test these concerns. If growth data come in strong, it will give the Fed more room to tighten; if inflation data beat expectations, it will reinforce the case for further rate hikes.
Goldman Sachs separately noted that once the 10-year Treasury yield rises about 30 basis points within two weeks or about 50 basis points within a month, equities tend to encounter clear resistance. The yield has already risen 28 basis points since September 9 and 37 basis points since August 21, approaching the threshold range indicated by historical experience.
Bulls are betting that yields will stabilize before borrowing costs further erode the stock market, and if energy prices peak and geopolitical tensions show signs of easing, a strong rebound is possible. But if energy prices stay high and economic data continue to support Fed tightening, the pressure on the market could intensify further.
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