Bonds Stymied as Inflation Data Fails to Break Fed-Hike Logjam

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(Bloomberg) — Bond traders’ expectations that August inflation data would resolve the question of another Federal Reserve interest-rate increase this year were dashed Wednesday, as the readings were close enough to expectations to keep the market on tenterhooks.

After briefly visiting session highs after the data, which included a bigger-than-anticipated increase in consumer prices excluding food and energy, Treasury yields retreated to little-changed levels. Interest-rate swaps tied to the next two Fed policy meetings continued to price in little chance of an increase on Sept. 20, and about 50% odds of one in November. 

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“The inflation theme is still around,” said Gang Hu, managing partner at Winshore Capital Partners, which specializes in inflation-protected investments. “So we move on. The key these days is oil,” where futures traded at year-to-date highs earlier Wednesday.

The two-year Treasury yield retreated to around 5%, lower on the day by about 2 basis points, after climbing to nearly 5.08% following the data. Evidence of dip-buying also was apparent in fed funds futures, where volume in the November contract surged.

The core consumer price index, which excludes food and energy, rose 0.3% from July vs economists’ 0.2% median estimate. From a year ago it increased 4.3%, in line with estimates and the smallest advance in nearly two years.

The inflation data has been viewed as the last piece of economic data with the potential to influence the outcome of next week’s Fed policy meeting, when policymakers are widely expected to keep their target range for the federal funds rate at 22-year high of 5.25%-5.5%. Beyond next week, swap rates price in about 15 basis points of tightening by year-end, marginally favoring another rate increase.  

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The upside surprise in core inflation was largely driven by airfare, which “is unlikely to change views about to path of inflation,” said Michael Pond, head of global inflation-linked research at Barclays Plc. Short-term inflation-protected Treasuries, relative to regular Treasuries, “offer the best value to trade upside inflation risk.”

In the two-year sector, inflation-protected yields are about 2.6 percentage points lower than nominal yields, up from about 2 percentage points at the start of the month, when oil was around $80.

The market’s next hurdle is a $20 billion auction of 30-year bonds at 1 pm. New York time. It’s expected to draw the highest yield for a sale of its type since 2011. 

Market yields have been driven higher in recent months not only by the prospect of the Fed maintaining its policy rate rather than pivoting to rate cuts next year, but also by growth in the supply of new notes and bonds to finance the US government’s widening budget gap. Auctions of three- and 10-year notes over the past two days drew the highest yields since 2007. 

(Adds market-implied inflation expectations, bond auction.)

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