US bond traders have started to reduce expectations for a Federal Reserve (Fed) interest rate hike after falling oil prices and more subdued inflation data boosted confidence in the outlook for price pressures. The development helped to strengthen the bond market as US Treasury yields fell across a range of maturities.
Oil Prices Fall, Inflation Starts to Easing
Benchmark oil prices fell more than 3.5% at one point on Thursday as investors assessed the latest developments in the conflict in the Middle East.
While some of the decline has since receded, the fall in energy prices still provided relief to the market as oil has been a major driver of US bond yields since the US-Iran conflict began in late February.
The situation has increased confidence that US inflationary pressures may have peaked.
Inflation Data Changes Fed Expectations
A much weaker-than-expected US jobs report last week initially dampened expectations for a Fed rate hike.
Sentiment was further supported after government data showed that producer price growth also slowed in July.
The day before, the consumer price report also showed inflationary pressures moderating for the second straight month.
The combination of data has traders increasingly less confident that the Fed will need to tighten monetary policy in the near future.
Rate Hike Probability Continues to Fall
The market is now placing a less than 40% probability that the Fed will raise interest rates at its September meeting.
Short-term interest rate contracts have also risen, indicating that traders are reducing their bets on a rate hike.
The December contract, which previously almost fully expected a 25 basis point hike, is now placing around 23 basis points of tightening.
The change suggests that market expectations are still biased towards a rate hike, but confidence in that scenario is waning.
Fed Officials Still Divided
While the market is increasingly confident that the Fed will not raise rates, some central bankers still see the need to act.
Cleveland Fed President Beth Hammack reiterated her stance that a rate hike is still warranted as inflation remains above the Fed’s 2% target.
The Fed's main inflation target rose to 3.6% in June, while July data is scheduled for release on August 26.
The divergence in views suggests that the debate over the direction of monetary policy is still not over.
Warsh to Give Key Guidance
Market attention is also now shifting to Fed Chairman Kevin Warsh, who is expected to speak at the annual central bank symposium in Jackson Hole in late August.
The speech could be an opportunity for Warsh to provide guidance on the direction of monetary policy and maintain the Fed's credibility in fighting inflation.
If his tone is more hawkish than expected, the bond market could face renewed pressure.
30-Year Bond Prints Record Yield
In the Treasury market, bond yields fell by as much as six basis points across several maturities.
However, 30-year bond yields fell more modestly after the US government sold US$25 billion of new bonds in an auction that recorded the highest yield for that maturity since 2001.
The bonds were offered at a yield of 5.216%, less than half a basis point higher than the yield before the auction.
That suggests demand was slightly weaker than expected, although high yields still attracted investors.
Markets Remain Cautious
While the softer inflation data provided support to the bond market, analysts warned that further increases could be more difficult.
If inflationary pressures pick up again, the market could potentially change expectations for a more aggressive rate hike in December.
That could send bond yields back up across the yield curve.
Market Impact
Lower oil prices and moderating US inflation are reducing pressure on the Fed to raise interest rates, supporting bond markets and riskier assets. Lower bond yields could also weigh on the US dollar if expectations of policy easing strengthen. However, any inflation shock or hawkish statement from the Fed could trigger a quick reversal in the market and push bond yields back up.
Key Takeaways
Bond traders are reducing bets on a Fed rate hike.
Oil prices fell more than 3.5% at one point on Thursday.
The probability of a Fed rate hike in September is now less than 40%.
December contracts are now pricing in around 23 basis points of tightening.
The Cleveland Fed still sees a rate hike as warranted given high inflation.
The Fed’s target inflation rose 3.6% in June.
The 30-year bond yield hit 5.216% in the latest auction, the highest since 2001.
While markets are increasingly confident the Fed will not raise rates anytime soon, a monetary policy decision is still far from certain. Investors are now looking ahead to the next inflation data and Kevin Warsh’s speech at Jackson Hole, both of which could potentially reshape interest rate expectations and the direction of the US bond market.
