Bonds suggest Fed can tame inflation without killing growth

(Bloomberg) — The bond market is signaling that when it comes to the Federal Reserve versus inflation, its money is on the U.S. central bank.

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Demand for inflation protection — as measured by yields on inflation-protected Treasury debt — continues to decline. The expected five-year inflation rate derived from these yields is back below 2.6%, from March’s peak of 3.76%. Meanwhile, the market’s expected peak in the Fed’s policy rate remains below 4%, and long-term bond yields have rebounded from levels that suggested a recession.

“If inflation falls to what it was priced in today, then a soft landing is possible,” said Rick Rieder, the head of global fixed income investments at BlackRock Inc., the world’s largest asset manager.

Yields on Treasury Inflation-Protected Securities, or TIPS, represent the market’s expectations of the annual rate of inflation for the debt to mature.

While commodity price trends explain the drop in short-term breakeven rates — crude oil and gasoline futures fell to their lowest levels since January this week — longer-term TIPS prices are back below 2 .5%, even as CPI inflation was 8.5% in July.

That’s a vote of confidence in Fed officials, including Chairman Jerome Powell, whose latest public comments on Thursday emphasized the importance of not allowing high inflation expectations to take root in consumers. “The clock is ticking” to keep those expectations in check, he said.

Powell’s comments largely bolstered the view that the Fed will opt for another three-quarter rate hike on Sept. 21, its next decision date, bringing the total amount of tightening since March to three percentage points. Fed Governor Christopher Waller and St. Louis Fed President Louis, James Bullard, speaking Friday, also argued for a larger increase. Fed officials typically avoid commenting during the week before a scheduled meeting, when it has already begun.

As recently as late August, a half-point rate hike was seen as the most likely outcome, based on the pricing of swaps quoted on Fed meeting dates.

It will now take much weaker-than-expected August inflation data — due on Tuesday — to rekindle talk of a smaller 50 basis point hike. In July, the annual CPI slowed more than expected to 8.5%. A further slowdown is estimated for August, to 8.0%.

Although swaps gave a more than 80% chance of a bigger rate hike in September, the expected peak of the Fed’s policy rate — in March 2023 — remained below 4%. The yield curve continues to price in a quarter-point interest rate cut from the high until the end of 2023, but just a month ago it was priced in at half a point.

Consistent with that, this week’s rise in longer-dated Treasury yields — the 30-year bond topped 3.51% for the first time since 2014 — reduced the yield curve’s inversion, effectively undercutting the odds of a recession.

To be sure, next week’s monthly three-, 10- and 30-year bond auctions on Monday and Tuesday could put upward pressure on yields that could then weaken. Next week also brings August retail sales data on Thursday and a measure of inflation expectations based on a University of Michigan survey on Friday.

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