Bond and interest-rate traders are weighing in with an early verdict that the Federal Reserve is likely to emerge victorious in its battle against inflation, just as the risks of being right about that are rising.
Fed funds futures traders are sticking with the likelihood of no further interest rate hikes in November, December or January — taking the edge off the recent selloff in Treasurys, which contributed to a three-year rout in government debt described as the worst bond bear market of all time, according to Bank of America’s Michael Hartnett. Treasury yields plunged on Tuesday, sending the policy-sensitive 2-year rate
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below 5% and pushing its long-dated counterparts into a steep dive.
Interestingly, the conclusions being drawn by bond and rates traders come just as Israel’s conflict with Hamas has ignited worries about a 1970s-type of stagflation outcome, with oil prices rallying more than 4% only a day ago. On Tuesday, however, oil settled lower, with November West Texas Intermediate crude at $85.97 a barrel — a sign that the market considers the war’s impact to be limited for now.
The move in oil “has been contained so far,” said Lawrence Gillum, a Charlotte, North Carolina-based fixed-income strategist for broker-dealer LPL Financial. “But if the conflict were to broaden out to include Iran and a 1973-style oil embargo, we could see inflation pick up. Bonds aren’t really priced for that right now. The bond market is expecting the Fed to win this inflation battle.”
The longer it takes for inflation to move meaningfully lower, however, “you get a problematic scenario where it’s hard to keep prices from going higher,” Gillum said via phone on Tuesday. “We haven’t seen that yet, but it probably won’t take many more months for that to start to happen.”
Indeed, just as many traders are settling into the idea that the Fed is likely done with rate hikes, another corner of the financial market is pointing to the risk that annual headline inflation may not budge much for months to come.
Inflation traders involved with derivatives-like instruments known as fixings expect the annual headline inflation rate from September’s consumer price index, which will be released on Thursday, to come in around 3.6% — in line with the median forecast of economists polled by The Wall Street Journal.
From there, fixings traders expect to see three more 3%-plus annual headline CPI readings for October through December — pulling back from prior expectations for such readings to stretch into early 2024, as oil prices move lower, said Gang Hu of New York hedge fund WinShore Capital Partners. Annual headline CPI readings matter because of their potential to sway household expectations, but Fed officials care more about core readings and even favor a different inflation gauge known as the PCE.
History shows that inflation tends to become harder to wipe out the longer that it persists, and oil-price shocks like the ones seen in the 1970s can be a major factor behind more persistent, broad-based price gains that require further Fed rate hikes.
Nothing in either the Treasury or inflation market indicates that the Fed has lost its inflation-fighting credibility yet, Hu said via phone. He’s expecting the annual core CPI rate, which strips out volatile food and energy components, to average 2.7% over the next 12 months. That compares with the 4%-plus annual core CPI levels that prevailed from June through August.
For now, a few policy makers are giving some credence to the likelihood that they may done with hiking rates. On Tuesday, Atlanta Fed President Raphael Bostic said he doesn’t think the central bank needs to raise interest rates anymore to bring inflation back to its 2% target.
Investors have also interpreted remarks made by Fed Vice Chair Philip Jefferson and Dallas Fed President Lorie Logan on Monday as suggesting a preference to pause, which would leave the central bank’s main policy target at a 22-year high of 5.25%-5.5%. There’s one big point that investors might currently be overlooking, however. The comments by Jefferson and Logan were said in the context of rising yields and, as of Tuesday, market-implied rates were in the midst of a steep dive instead — leaving open the possibility that the Fed might hike again if needed, analysts said. In fact, Logan kept that option open.
“All the comments in the past week or week-and-a-half, which traders interpreted as dovish … well, those comments are negated if yields are lower,” said Will Compernolle, a macro strategist for FHN Financial in New York.
“Financial conditions have gotten looser and, in circular logic, that means they could hike again,” Compernolle said via phone. “Markets, so far, are kind of too quick to dismiss the possibility of another hike in December or January. Right now, we don’t see anything happening in November, but the CPI numbers could change that.”
On Tuesday, a selloff in government debt gathered momentum heading into New York afternoon trading. The 10-year Treasury yield
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plunged to roughly 4.65%, heading for one of its lowest closes of this month. The yield on the 30-year Treasury
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fell to around 4.82%, leaving it on track for its lowest closing level since at least Oct. 2. Meanwhile, all three major U.S. stock indexes
DJIA
SPX
COMP
were higher during the final hour of trading on hopes that the Fed’s job is done.
