Bond traders are bracing for the risk that inflation will fuel rate hike bets

(Bloomberg) — Bond traders are betting the Federal Reserve isn’t done raising interest rates yet. Next week will help find out if they are right.

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Wednesday’s monthly consumer price index report will provide the latest insight into how far the central bank may have to go to bring inflation back toward its target. As the economy defies dire forecasts and energy prices rise, economists are predicting the biggest monthly rise in 14 months – and the swap market is pricing in the risk that it will be even higher than expected.

The numbers could provide a boost to the Treasury market, which has come under pressure as the surprisingly strong pace of growth has investors bracing for monetary policy to remain restrictive for longer than expected.

While signs of a slowdown in the labor market fueled optimism that the Fed could be ready, futures traders see about a 50 percent chance it will raise rates again in November after a move at the April 19-20 meeting. September remained stable. That puts government bonds on track for a third straight annual loss as yields hover near their highest levels since the 2008 financial crisis.

“Next week’s CPI data could add a little more color to the Fed’s likely path,” said Leslie Falconio, head of taxable fixed income strategy at UBS Global Wealth Management. “We do not expect the Fed to take action in September. But even if we say at this point that they won’t move even in November, you really have to give it a 50/50 chance.”

The pace of inflation remained stubbornly above the Fed’s 2 percent target, although it has declined significantly from last year’s four-decade high.

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The consumer price index growth rate is expected to have accelerated to 3.6% in August compared to a year earlier, although the core measure – which excludes food and energy costs – bounced back to 4.3%, according to the median estimate of economists surveyed. declined from Bloomberg. But on a monthly basis, headline CPI is expected to rise 0.6%, the sharpest increase since inflation peaked in June 2022.

Fed officials have repeatedly stressed that they remain aware of upside risks to inflation and may need to keep interest rates high even if they stop raising them.

New York Fed President John Williams said Thursday that monetary policy is “in good shape” but that officials need to analyze the data to decide how to proceed.

The Fed raised its key interest rate in July to a range of 5.25% to 5.5%, the highest in 22 years, after holding steady in June. Policymakers have not ruled out the possibility of another rate hike this year, and Fed Chairman Jerome Powell has stressed that their path will depend on upcoming economic data.

What Bloomberg Economics says…

“We expect overall monthly CPI to accelerate to 0.6% (vs. 0.2% in July) due to higher gasoline prices, with the year-on-year reading at 3.6% (vs. 3.2%) lies. The market may conclude that the Fed needs to raise rates further, but we believe that is the wrong conclusion.”

—Anna Wong, chief US economist

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That’s keeping the bond market tense as all the key data comes in and traders try to figure out whether the Fed’s interest rate has already peaked. Next week there are expected to be no comments from Fed officials, who typically remain silent ahead of their meetings.

The market is also trying to gauge the extent to which the Fed can ease monetary policy next year given the strength of the economy and persistent inflation pressures. The price of futures on the central bank’s benchmark through the end of 2024 is around 4.4%, well above the rate of around 2.5% that is considered neutral for economic growth.

The bond market also struggled with a flurry of new debt sales to cover the rising federal budget deficit, adding to upward pressure on long-term yields. And investors have been pulling out of long-dated bonds, betting that their yields will rise above short-term ones again after the Fed returns to easing monetary policy.

The Treasury market is “now in prime U.S. yield territory,” said William Marshall, head of U.S. interest rate strategy at BNP Paribas. Still, an impending rally in Treasuries “will not result in a significant decline in longer-term yields,” which would support a steeper yield curve through 2024, he said.

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