(Bloomberg) — Bond investors betting on a Federal Reserve interest rate cut next month face a potential roadblock: inflation.
July’s consumer price index, due on Tuesday, will give traders clues on how President Donald Trump’s tariffs are affecting costs. Economists surveyed by Bloomberg expect the annual core inflation rate to rise to 3%, the highest since February.
“The market is looking for further confirmation that changes to trade policy are passing through into higher goods inflation,” said Gennadiy Goldberg, head of US rates strategy at TD Securities, “All else equal, a higher inflation print could leave the Fed wanting to see more data before cutting rates.”
That would disappoint investors, who are betting on two rate cuts by the end of the year, starting as soon as September. Signs of a weakening US job market bolstered their belief that it was time for the first cut since December. Treasury yields have fallen to levels seen in late April and a gauge of their total returns delivered broad gains of 4% this year, on course for its best annual run since 2020.
The 10-year benchmark yield was little changed at 4.28% in Asia trading Tuesday.
Since the soft July payrolls report, bond traders’ activity in the options market has largely targeted a deeper and longer path of rate cuts over the coming months.
Investors have been actively betting that a quarter-point rate cut will remain likely for the Fed’s Sept. 17 meeting. Meanwhile, some are positioning for inflation data that could give the Fed a green light for a half-point cut, shown by Monday activity in options linked to the Secured Overnight Financing Rate, which closely tracks the expected path of US monetary policy.
If the CPI number is in-line with market expectations, the “carry” on long positions on Treasury Inflation-Protected Securities will likely turn negative in September, JPMorgan Chase & Co. strategists said Monday, adding they remain neutral on breakeven rates ahead of the data.
However, the risk of fast-rising prices is top of mind for Fed Chair Jerome Powell as well as some on Wall Street. Recent notes from Bank of America Corp., Apollo Global Management Inc. and Bank of New York Mellon Corp. have flagged stagflation as a significant concern.
The combination of persistently high inflation and sluggish economic growth is also a risk to the dollar, which has weakened nearly 8% against a basket of peers this year. Strategists at TD Securities on Monday said the slump will deepen under a stagflation scenario.
Sticky inflation would temper the Fed’s ability to ease rates towards the 3% area being priced by swaps over the next 12 months. It could also put upward pressure on Treasury yields, which rose last week after a trio of soft auctions for the securities reflected waning demand for US government debt ahead of the CPI report.
If inflation continued rising in July, that “would reinforce what Powell has said about their dual-mandate — of stable employment and inflation — coming into conflict,” said George Catrambone, head of fixed income at DWS Americas. Policymakers will also have to consider the August CPI reading before the September decision, as well as a report on producer prices due Thursday.
After the Fed held rates last month, Powell reiterated that officials needed more time to gauge the impact of tariffs before cutting rates, signaling patience in the face of Trump’s relentless pressure on him to lower borrowing costs.
However, Governors Christopher Waller and Michelle Bowman — both appointed by Trump — dissented, favoring an immediate rate reduction because of labor market weakness. If the president’s economic adviser Stephen Miran is approved by the Senate to become a Fed Governor, that’ll be one more dovish voice in the room, according to JPMorgan.
What Bloomberg strategists say…
“The market is still pricing closer to two rate cuts this year than three, though September is discounted as something close to a done deal. To meaningfully sway that, it would probably take an upside surprise not only on tomorrow’s inflation figure, but also on the August payroll figures to be released on Sept. 5.”
— Cameron Crise, Markets Live. Click here for the full analysis.
Despite forecasts showing that price growth will remain above the Fed’s 2% target, Vanguard Asset Management’s Roger Hallam expects rate-setters to focus on signs of a shaky job market, barring a big upside inflation shock.
“When push comes to shove, the Fed would prioritize the labor market in anything other than extreme inflation scenarios,” said Hallam, the firm’s global head of rates. The labor market has shown enough softness that “the probability of easing in September has gone up a lot,” he said.
–With assistance from Edward Bolingbroke.
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