Treasury Yields Rise as Traders See Fewer Chances of the Fed Cutting Rates by Half a Point Next Month

On Wednesday morning, the yield on the 2-year Treasury note, which is particularly sensitive to changes in Federal Reserve policy, experienced a slight increase following the release of July’s consumer-price index (CPI) report. The data largely aligned with expectations, leading traders to reassess the likelihood of a more substantial rate cut from the Fed next month.

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Market Movements

The yield on the 2-year Treasury rose by 3.4 basis points to 3.977%, up from 3.943% on Tuesday. Meanwhile, the 10-year Treasury yield saw a modest increase of less than 1 basis point, reaching 3.857% from its previous 3.853%. In contrast, the yield on the 30-year Treasury dipped slightly, falling by 1.8 basis points to 4.148% from Tuesday's 4.166%.

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Factors Influencing the Market

The key driver behind these movements was the CPI data released on Wednesday. The annual headline inflation rate for July came in at 2.9%, the lowest level since March 2021, and slightly below the 3% rate economists had anticipated. On a monthly basis, both the overall CPI and the core CPI, which excludes volatile items like food and energy, rose by 0.2%, in line with expectations. Additionally, the annual core inflation rate, which had previously been at 3.3%, edged down to 3.2%, marking its lowest level in three years and again matching forecasts.

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The CPI report followed Tuesday’s producer price index (PPI) data, which indicated that price pressures further down the supply chain had increased less than expected. This sequence of reports has provided some reassurance to the markets that inflation is continuing to moderate, albeit slowly.

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Impact on Rate Cut Expectations

In response to the CPI data, traders in the fed-funds futures market adjusted their expectations regarding the Federal Reserve's next move. As of Wednesday morning, the probability of the Fed cutting interest rates by 25 basis points, from the current range of 5.25% to 5.50%, by September was pegged at 58.5%, according to the CME FedWatch Tool. This represents a slight shift from earlier expectations, where the likelihood of a larger 50-basis-point rate cut was higher. The chance of such a substantial cut has now decreased to 41.5%, down from 53% the previous day.

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This shift in expectations reflects a broader sense of cautious optimism among market participants. While the CPI data shows that inflation is gradually easing, the Fed's commitment to maintaining price stability means that it is likely to proceed with caution when it comes to rate cuts. The reduced probability of a larger rate cut suggests that traders believe the Fed will likely opt for a more measured approach, waiting for more conclusive evidence of sustained inflation moderation before making any drastic policy changes.

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Broader Market Context

These developments are taking place in a broader market context where investors are closely monitoring economic indicators to gauge the Fed's next steps. The slight rise in shorter-term Treasury yields, like the 2-year note, indicates that traders are pricing in a scenario where the Fed might be more cautious in its rate-cutting approach than previously anticipated.

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At the same time, the more modest changes in longer-term yields, such as those on the 10-year and 30-year Treasuries, suggest that the market remains uncertain about the longer-term trajectory of inflation and economic growth. The dip in the 30-year yield, in particular, could be indicative of concerns about future economic conditions and the potential for a slower growth environment.

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Conclusion

Wednesday’s Treasury yield movements, influenced by the CPI data release, highlight the delicate balance the Federal Reserve must strike as it navigates the dual challenges of moderating inflation and sustaining economic growth. The market’s reaction, characterized by a slight uptick in the 2-year yield and modest changes in longer-term yields, reflects a cautious reassessment of the likelihood of significant rate cuts in the near term.

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While traders still see a more than even chance of a 25-basis-point cut in September, the reduced probability of a larger 50-basis-point cut underscores the uncertainty surrounding the Fed’s next moves. As the Fed continues to monitor inflation trends and other economic indicators, market participants will remain focused on incoming data to better understand the likely path of monetary policy in the months ahead.

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