Traders Capitulate, Abandoning Fed Rate Cut Bets After CPI Spike

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(Bloomberg) — Bond traders were once again forced to rethink the Federal Reserve’s path after inflation data showed prices remain stubbornly high. They now expect the Fed to continue raising interest rates through June and no longer see a rate cut as a sure bet this year.

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Treasury yields rose Tuesday, with the rate on the two-year note, more sensitive than longer maturities to Fed policy changes, climbing as much as 12 basis points to nearly 4.64%, the highest since November and within 20 basis points of last year’s multiyear high. Three- and five-year yields also reached 2023 highs. Rates stabilized at elevated levels as the day progressed yet could see a renewed push higher in Asia trading hours.

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Traders aggressively ramped up bets on policy hikes by the Fed and did the same for many of its global central bank peers. The market for wagers on the Fed’s policy rate boosted the chances of a quarter-point rate increase in June to about 50%, assuming moves of that size in March and May, and trimmed the odds that the central bank will cut rates from the eventual peak level this year. The rate on the June overnight index swap contract rose to 5.22%, about 64 basis points above the current effective fed funds rate. 

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The January consumer price index data “brings back the likelihood of a third interest rate hike,” Saira Malik, chief investment officer at Nuveen, said on Bloomberg Television. “If you look under the hood” of the data it shows some inflation sectors, like shelter, are proving “very sticky.”

The market also priced in a higher eventual peak for the Fed policy rate, with the July contract’s rate rising to 5.28%, and repriced the odds of a quarter-point rate cut from the peak by year-end to less than 100%.

As recently as mid-January the market priced in rate cuts totaling more than half a percentage point, reflecting expectations that the Fed’s eight rate increases in the past year have sown the seeds of a recession that will require the central bank to reverse course.

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Those expectations have faded since the Feb. 3 release of much stronger than expected US employment data for January.

Hot UK wages data as well as the US CPI data pushed wagers up that the Bank of England and European Central Bank will also raise their benchmark policy rates to even higher peak levels than previously assumed. 

Hot Data Has Traders Betting Central Banks Will Go Even Higher

Longer-maturity yields rose less, the 10-year by as much as about 9 basis points to around 3.8% before trailing off to 3.75% later in the afternoon. The move in yields spurred further inversion the curve, leaving the 2-year about 87 basis points higher than the 10-year.

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The Fed has raised its policy rate eight times since March 2022, most recently to a range of 4.5%-4.75% on Feb. 1, after dropping the lower bound to 0% at the onset of the pandemic. In December, the median forecast by Fed officials was for the policy rate to end the year at about 5.1%. Those forecasts, which come as part of the Fed’s summary of economic predictions — dubbed the SEPs — will be updated in March. 

The consumer price index climbed 0.5% in January, up 6.4% from a year earlier. Core CPI, which excludes food and energy, advanced 0.4% last month and was up 5.6% from a year earlier. 

Dominique Dwor-Frecaut, a senior market strategist at the research firm Macro Hive, said on Bloomberg Television Tuesday that the consumer price figures bolstered her prediction that the funds rate will peak near 8%.

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“In March, the Fed will add one or two hikes to the terminal fed funds rate” in the new SEPs, Dwor-Frecaut said. “Then we’ll have a recovery in energy prices because China is coming back on stream. That triggers a recovery in core inflation. Then the Fed is behind the curve and tries to catch up,” with the December SEPs likely showing a “terminal fed funds in the 7 to 8% range.” 

The five-year Treasury note’s yield rose as much as 12 basis points to 4.03%. It dipped below 3.4% in January. Meanwhile, six-month bills traded at a 5% yield, the first US government obligation to reach the threshold since 2007.

Economists at LH Meyer in Washington changed their Fed call after the CPI report, now predicting the US central bank gets to a terminal rate range this year of 5.25% to 5.50%, up from their prior prediction for a peak in the 5%-5.25% band.

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Richmond Fed President Thomas Barkin said after the CPI data was released that the central bank may need to raise interest rates to a higher level than previously anticipated should inflation keep running too fast for comfort.  Philadelphia President Patrick Harker said he believes policymakers will need to raise interest rates to some level above 5% to counter inflation that is retreating only slowly.

Barkin Says Fed May Extend Rate Hikes If Inflation Persists

“This morning’s inflation figure has changed the narrative on disinflation as energy prices posted a larger than expected increase,” said Thomas di Galoma, co-head of global rates trading at BTIG. “I expect the Fed’s hawkish rhetoric should continue.”

(Adds comment’s from Fed’s Patrick Harker in 13th paragraph.)