Expectations for Fed rate hike increase, market focuses on inflation data and Warsh hearing
Bond traders have ramped up bets on a rate hike in July ahead of the release of U.S. inflation data and the Federal Reserve chairman's testimony on Capitol Hill. Expectations of rising interest rates are evident in the interest rate options market and the U.S. Treasury market. Interest rate options trends show that the market-implied probability of a 25 basis point interest rate hike later this month has risen from less than 10% to about 50%. In the U.S. Treasury market, the 2-year yield, which is more sensitive to interest rate changes, remained above 4.25% on Tuesday, widening the gap with policy rates. “There’s a possibility of a rate hike in July,” said Ed Al-Hussainy, portfolio manager at Columbia Threadneedle, who believes a rate hike is more likely than no change. Although the PCE price index, the Fed's preferred inflation measure, rose 4.1% year-on-year in May, slightly lower than the CPI increase that month, "we need some luck to get the inflation rate back to 2%." Market tightening expectations grew after Fed Governor Christopher Waller said that if inflation data showed core prices were "high again," a rate hike should be considered "in the near term." Until recently, Waller was one of the central bank's most dovish officials. June CPI data will be released on Tuesday at 8:30 Washington time. Headline and core inflation were expected to fall for the first time since January, according to the survey's median forecast. In May, these two indicators were 4.2% and 2.9% respectively. Still, bond traders are increasingly concerned that only higher interest rates can push inflation back to the Fed's 2% target. Oil prices continued their gains on Tuesday, as the U.S. military is expected to resume blockades of Iranian ports and Trump said he would continue to strike Iran. Fed Chairman Kevin Warsh's reluctance to predict where policy will go adds to the pressure. Warsh will testify before Congress on Tuesday and Wednesday on the Fed's semiannual monetary policy report. Al-Hussainy said the short-term interest rate market has determined that the Federal Reserve will raise interest rates once before the end of the year and again before mid-2027, but this may not be enough. He believes the Fed is likely to roll back the three 25-basis point interest rate cuts it implemented in the last four months of last year in response to labor market weakness. The odds have grown since Warsh spoke at the European Central Bank's annual symposium in Sintra, Portugal, on July 1. Bets on recent interest rate hikes by the Federal Reserve flooded into the interest rate futures market, pushing up open interest in August federal funds futures. In July, the number of contracts held by traders increased by about 23%. The open interest figure is released after the close and is set to increase further based on trading activity on Monday. The CPI report is expected to show that the overall CPI fell by 0.1% month-on-month in June, with the year-on-year increase falling from 4.2% to 3.8%. Core CPI is expected to rise 0.2% month-on-month and 2.8% year-on-year. Even if the CPI data is lower than expected, the boost to the bond market may be limited. This month, the 2-year U.S. Treasury yield has risen by about 10 basis points, and the 10-year yield has risen by 15 basis points. The market growth this year as measured by the Bloomberg U.S. Treasury Index has returned to zero.