(Bloomberg) — Bond investors battered by the wildest swings in decades are gearing up for their next big test: Navigating the Federal Reserve’s response to growing financial volatility that threatens to derail the fight against inflation.

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Regardless of what the central bank does, investors have suffered further as volatility rises to levels not seen since the 2008 financial crisis. The recent decline in Treasury yields and the sudden recalibration in Fed rate bets are suggesting another 25 basis-point hike is the most likely scenario at this stage. What’s happening now is that Wall Street is really worried about what the authorities will do next.

Traders currently see the central bank’s benchmark ending the year around 3.8%, a full percentage point below the Fed’s rate estimate in the December “dot plot” that comes as part of quarterly economic projections. It’s a dire scenario that could hit a wall on Wednesday when new forecasts come out.

Inflation has remained high and the labor market has shown resilience despite the most aggressive tightening campaign in decades. Whether the Fed remains focused on that or prioritizes concerns about the health of the financial system could determine the way rates move forward.

“It’s a two-way risk right now, and maybe more than that,” said market veteran David Robin, strategist at TJM Institutional in New York. “The only Fed move off the table is a 50 basis-point hike. Otherwise, there are many policy possibilities and even more reaction-action possibilities. It will feel like an eternity until 2pm next Wednesday.”

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Amid all the angst, the widely watched MOVE index, an options-based measure of expected volatility in Treasuries, hit 199 on Wednesday, nearly doubling from late January. The yield on US two-year notes, typically a low-risk investment, swung between 3.71% and 4.53% this week, the widest weekly range since September 2008.

The Federal Open Market Committee will raise rates by a quarter point at its March 21-22 meeting from the current 4.5%-4.75% range, according to economists polled by Bloomberg News. Fed Chairman Jerome Powell has raised the possibility of a return to a bigger move, meaning half a point or more, if warranted by economic data. But that was before worries about the banking system sent markets reeling.

Even with the turmoil surrounding Credit Suisse Group AG and some US regional lenders, the European Central Bank went ahead with a planned half-point hike on Thursday – but offered very few hints on what might follow.

The issue now is whether recent banking problems will hamper the Fed’s ability to fix price gains that, while moderating, remain above the 2% target.

“The most painful outcome will be the Fed saying we have this financial stability problem, and it’s being solved,” said Ed El-Hussaini, rates strategist at Columbia Threadneedle Investments. Then, the Fed will be able to stick with its fight to keep inflation anchored and tight, he said. “This is an outcome that the market is not ready for at this stage.”

This raises the question of whether the little change in market pricing has gone too far.

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Dot plot

Back in December, US officials estimated they would raise rates at a slower pace, with the median projection putting the benchmark at 5.1% by the end of 2023. After Powell’s comments to US lawmakers on March 7, bets for a new dot plot increased. Tightening – Swap traders raising expectations for peak rate to 5.7%.

Those bettors quickly fizzled amid fears of a wider banking crisis that could lead to a debt crisis, as bets on an economic downturn were running. Now swap traders are betting that Fed tightening will peak at around 4.8% in May, with rates coming down by the end of 2023.

Any hawkish surprise from the Fed’s dot plot will shock investors — especially after the big rally in Treasuries this month.

For Anna Dreyer, co-portfolio manager of the Total Return Fund at T. Rowe Price, the only certainty amid all the uncertainty is the “tug of war” between banking transitions and inflation concerns. This will continue to drive sentiment in the rate market.

Ashish Shah, chief investment officer of public investing at Goldman Sachs Asset Management, said, “We don’t know how much tightening they will do and what impact that will have on US growth and the economy. “Banks are going to set higher thresholds for lending and that will have the effect of slowing growth. The bottom line for investors is that they have to price in more uncertainty in both directions for interest rates.”

what to watch

  • Economic data calendar

    • March 21: Philadelphia Fed manufacturing index; Existing home sale

    • March 22: MBA mortgage applications

    • March 23: Jobless claims; current account balance; Chicago Fed National Activity Index; new home sales; Kansas City Fed Manufacturing Index

    • March 24: Durable goods orders; capital goods order; S&P Global US Manufacturing and Services PMIs; Kansas City Fed Service Activity

  • Federal Reserve Calendar

  • Auction Calendar:

    • March 20: 13- and 26-week bills

    • March 21: 52-week bill; 20 year bond

    • March 22: 17-week bills

    • March 23: 4- and 8-week bills; 10-Year Treasury Inflation Protected Securities

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