(Bloomberg) -- Bond investors battered by the wildest swings in decades are hunkering down for their next big test: navigating the Federal Reserve's response to the mounting financial instability that threatens to derail its fight against inflation.

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No matter what the central bank does, investors face more pain after volatility surged to levels not seen since the 2008 financial crisis. The recent plunge in Treasury yields and the abrupt recalibration in Fed rate bets are signaling one more 25 basis-point hike is the most likely scenario at this stage. Now what's getting Wall Street really anxious is what officials will do after that.

Traders currently see the central bank's benchmark ending the year around 3.8%, more than a whole percentage point below the Fed's rate estimate in the December "dot plot" that comes as part of the quarterly economic projections. It's a dovish scenario that could hit a wall Wednesday when the new forecasts come out.

Inflation has remained elevated and the labor market has shown resilience despite the most-aggressive tightening campaign in decades. Whether the Fed chooses to stay focused on that or prioritize concerns about the health of the financial system could determine the path for rates forward.

"It's is two-way risk now, and probably even more than that," said rates market veteran David Robin, a strategist at TJM Institutional in New York. "The only Fed move that is definitely off the table is a 50 basis-point hike. Otherwise, there are multiple policy probabilities and even more reaction-function probabilities. It's going to feel like an eternity until next Wednesday at 2 p.m."

Amid all the angst, the widely watched MOVE index, an options-based measure of expected volatility in Treasuries, hit 199 points on Wednesday, having roughly doubled since the end of January. The yield on US two-year notes, normally a low-risk investment, has 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 surveyed by Bloomberg News. Fed Chair Jerome Powell has raised the possibility of reverting to bigger moves, meaning a half point or more, if warranted by economic data. But that was before concerns about the banking system sent markets reeling.

Even with the turmoil that has engulfed Credit Suisse Group AG and some American regional lenders, the European Central Bank went ahead with a planned half-point hike on Thursday - but offered very few clues on what may follow.

Now the issue is whether the recent banking woes will constrain the Fed's ability to tackle price gains that, while moderating, remain well above the 2% target.

"The most-painful outcome would be a Fed that comes in and says we have this financial stability issue, and it's being resolved," said Ed Al-Hussainy, a rates strategist at Columbia Threadneedle Investments. Then, the Fed would be able to stick with its battle to anchor inflation and continue tightening, he said. "That's an outcome the market is not prepared for at this stage."

That begs the question on whether the shift lower in market pricing has now gone too far.

Dot Plot

Back in December, US officials forecast they would lift rates at a slow pace, with the median projection putting the benchmark at 5.1% at the end of 2023. After Powell's remarks to American lawmakers on March 7, bets for the new dot plot showed additional tightening - with swap traders pushing up expectations for the peak rate to around 5.7%.

Those wagers quickly fizzled out amid fears of a widespread banking crisis that could cause a credit crunch at a time when bets on an economic recession are running rampant. Now swap traders are betting that Fed tightening will peak at just about 4.8% in May, with rates coming down through the end of 2023.

Any hawkish surprise from the Fed's dot plot would deliver a blow to investors - especially after the big rally in Treasuries this month.

To Anna Dreyer, co-portfolio manager of the Total Return Fund at T. Rowe Price, the only sure thing amid all the uncertainties is the "tug of war" between banking contagion and inflation concerns. That's what will continue driving sentiment in the rates market.

"What we don't know is how far they tighten and what is the impact on US growth and the economy," said Ashish Shah, chief investment officer of public investing at Goldman Sachs Asset Management. "Banks are going to set a higher threshold for lending and that will have the effect of slowing down growth. The conclusion for investors is that they should price in more uncertainty in both directions for interest rates."

What to Watch

• Economic data calendar

  • March 21: Philadelphia Fed manufacturing index; existing home sales

  • 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 orders; S&P Global US manufacturing and services PMIs; Kansas City Fed services activity

• Federal Reserve calendar

  • March 21: Federal Open Market Committee meeting begins

  • March 22: FOMC rate decision; Fed Chair Jerome Powell press conference

• Auction calendar:

  • March 20: 13- and 26-week bills

  • March 21: 52-week bills; 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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