For most of this year, bond investors were almost certain that the Federal Reserve (Fed) would resume cutting interest rates in September. But recently, that confidence has begun to waver. These nascent doubts put this week's inflation data in the spotlight. It will affect market expectations for the Fed's next move and will also determine whether US Treasuries can continue their solid performance from the first half of the year. Even after several sharp swings, US Treasuries posted their best first-half performance in five years.
"CPI data could set the tone for the Fed's policy direction and risk sentiment in the second half of the year," said Zachary Griffiths, head of investment-grade credit and macro strategy at CreditSights.
Strong employment data in early July led traders to rule out a rate cut at this month's Fed meeting. Currently, they see the probability of a rate cut at the September meeting at about 70% - whereas at the end of June, the market considered the cut a "done deal."
Against this backdrop, the June Consumer Price Index (CPI), released on Tuesday, takes on particular importance. Barclays Plc strategists state that the June CPI has the largest average absolute deviation from expectations in recent years, meaning a surprise is more likely.
If the data shows that price pressures are rising against the backdrop of Trump's tariff policy, it could trigger more doubts about a rate cut in September, thereby supporting positions betting on rising US Treasury yields. Conversely, if the data is benign, it could reactivate bets on short-term monetary policy easing.
"Future inflation reports should reflect the impact of the tariff war," said Tracy Chen, portfolio manager at Brandywine Global Investment Management. "I don't think the Fed will cut rates in September. The resilience of the labor market and the bubbles in the asset markets do not support a rate cut."
She believes that given that long-term bonds are susceptible to rising inflation, government spending prospects, and changes in overseas demand, the yield curve is likely to steepen.
The Fed will receive two more CPI reports before making a decision in September. Fed Chairman Jerome Powell has said that officials need more time to assess the impact of tariffs before cutting rates, suggesting that he remains patient amid continued pressure from Trump to cut rates.
Tariffs have sparked divisions among policymakers, and after Trump delayed the deadline for punitive tariffs on trading partners to August 1, the clarity of the issue has further decreased.
As a result, traders lack confidence about the next direction of the world's largest bond market, leading to a significant unwinding of bullish positions in the past week.
This wait-and-see state has temporarily trapped US Treasury yields in a range: the yield on the two-year Treasury, which is most sensitive to Fed expectations, has fluctuated between about 3.7% and 4% since the beginning of May. At the same time, a measure of expected volatility for US Treasuries has fallen to its lowest level in more than three years, after reaching highs in April driven by tariffs.
"Ahead of this week's inflation and consumer spending data, US Treasury yields were at the midpoint of the 2025 range," said Alyce Andres, Bloomberg foreign exchange/interest rate strategist. "Expectations for these data may cause bond yields to fluctuate within a familiar range - and the buy-the-dip, sell-the-rally pattern is still ongoing."
Investors concerned about hot inflation data leading to a continued decline in Treasuries may find solace in last week's 10-year and 30-year Treasury auctions: strong demand suggests that buyers may step in to limit the sell-off.
Policymakers have held interest rates steady since last December's cut. Powell described current interest rate levels as "moderately restrictive," and the median forecast of the Fed's "dot plot" released last month showed two rate cuts by the end of the year.
However, seven officials believe there will be no rate cuts in 2025, and 10 officials believe there will be two or more. Fed Governors Waller and Bowman have signaled they hope to resume rate cuts as early as this month.
"We remain concerned that tariff pressure on consumer prices will become more apparent, forcing the market to reprice the Fed's policy path, pushing bond yields into a slightly higher overall trend, reflecting a bear-flattening shape," Griffiths said.
John Lloyd, global head of multi-sector credit at Janus Henderson, believes that even if the next rate cut is delayed beyond September, it may not change the overall trend toward easing - a view that may limit bond declines.
"The market has priced in two rate cuts before December," he said. "Could one of them be cancelled? It's possible, but it's likely just pushed out to the first quarter of next year."
Economic indicators like CPI provide insight into the overall health of the economy. A rising CPI generally indicates inflation, while a falling CPI may indicate deflation. The Federal Reserve uses these indicators to make decisions about monetary policy, such as adjusting interest rates. Keeping informed about these indicators helps investors to better understand market trends and make more informed decisions.
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