Next Trading Session's Likely Market Moves

Treasury yields rebounded from their lowest levels of the year following the release of key inflation data on Wednesday. The higher-than-expected inflation figure in the August consumer price index (CPI) report dampened the likelihood of a larger interest rate cut by the Federal Reserve during its meeting next week.

‍

Market Movements

The yield on the 2-year Treasury note rose by 5.5 basis points to 3.663%, up from Tuesday’s level of 3.608%. Tuesday’s closing yield was the lowest since September 12, 2022. Similarly, the yield on the 10-year Treasury note increased by 3.5 basis points to 3.678%, compared to Tuesday’s level of 3.643%, which was the lowest since June 1, 2023. The 30-year Treasury bond yield also rose, gaining 2.7 basis points to reach 3.981%, after closing at 3.954% the previous day. That level marked the lowest yield since December 27, 2022.

‍

Drivers Behind the Market Shifts

Wednesday’s CPI data showed that the core inflation rate for August, which excludes volatile food and energy prices, rose by 0.3%. This was slightly above economists’ median estimate of 0.2%. The higher-than-anticipated inflation rate has cast doubt on the possibility of a large, 50-basis-point interest rate cut by the Federal Reserve. As a result, traders have scaled back their expectations for a more aggressive rate cut when the Fed meets next Wednesday.

‍

According to data from the CME FedWatch Tool, as of Wednesday morning, there is now an 83% chance that the Fed will opt for a more modest, 25-basis-point rate cut, which would bring the federal funds rate to a range of 5.00% to 5.25%. This is down from a 34% chance of a 50-basis-point cut the day before, which has now fallen to just 17%.

‍

Despite this shift, market participants are still expecting the Federal Reserve to cut rates by at least 100 basis points by the end of the year, indicating that concerns about a possible economic slowdown in the U.S. persist.

‍

Later in the day, the Treasury was scheduled to conduct a $39 billion auction of 10-year Treasury notes, the results of which were to be released in the early afternoon.

‍

Analyst Insights

Quincy Krosby, chief global strategist for LPL Financial, weighed in on the inflation data and its impact on Treasury yields. According to Krosby, the CPI report suggests that the Fed will likely begin its easing cycle with a 25-basis-point rate cut, rather than the 50-basis-point cut that some had hoped for. The modest increase in the 10-year Treasury yield following the report reflects the bond market’s alignment with this expectation, as yields have been trending downward in recent days.

‍

Krosby emphasized that Wednesday’s inflation data should reassure markets that the threat of deflation driven by economic concerns has been averted, at least for the time being. As a result, markets remain confident that a 25-basis-point rate cut will be announced at the Fed’s upcoming policy meeting on September 18.

‍

The overall message from Wednesday’s market activity is that inflation remains a significant factor in the Federal Reserve’s decision-making process. Although the core CPI came in slightly higher than expected, it was not enough to justify a larger, 50-basis-point cut. Instead, the Fed appears to be leaning toward a smaller rate cut as it navigates the delicate balance between controlling inflation and supporting economic growth.

‍

The Broader Economic Context

While inflation is still above the Fed’s 2% target, the higher-than-expected core CPI reading suggests that inflationary pressures, although moderating, are not entirely under control. This complicates the Fed’s task of managing the dual risks of inflation and economic slowdown. On one hand, a more aggressive rate cut could stimulate economic activity, but on the other hand, it could reignite inflationary pressures. The modest increase in Treasury yields signals that investors are preparing for a slower pace of rate cuts, with the expectation that the Fed will prioritize keeping inflation in check.

‍

Meanwhile, concerns about a potential economic slowdown in the U.S. remain, as reflected in traders' expectations for further rate cuts by year-end. The fact that markets are still pricing in at least 100 basis points of easing by the end of 2023 indicates that investors are hedging against the possibility of weaker-than-expected economic data in the coming months.

‍

Looking Ahead

The next few months will be critical for the Federal Reserve as it assesses the impact of its interest rate decisions on the economy. While the immediate focus is on the September meeting, where a 25-basis-point cut is now the most likely outcome, future rate cuts will depend on how inflation and economic growth evolve. The Fed will need to remain flexible as it navigates a complex economic landscape, with inflation showing signs of persistence even as concerns about a broader economic slowdown loom in the background.

‍

For now, the bond market’s response to the inflation data suggests cautious optimism that the Fed can manage inflation while avoiding a deeper economic downturn. However, with uncertainty still lingering, market participants will be closely monitoring upcoming economic data and Fed communications for any further clues about the central bank’s future policy moves.

‍