The Federal Reserve has initiated a new round of monetary easing by cutting interest rates by 50 basis points. However, this aggressive move has reignited inflation concerns in the U.S. bond market, with some investors worried that the relaxation of financial conditions might reignite price pressures.
Long-term U.S. Treasury yields, which are most sensitive to inflation prospects, have risen to their highest levels since early September. Some investors are concerned that the Fed's shift in focus from curbing inflation to protecting the job market could lead to a rebound in price pressures.
Cayla Seder, Global Macro Multi-Asset Strategist at State Street Global Advisors, said: "I think if we're in a rate-cutting environment and the Fed indicates that they want to provide support before the job market weakens, there will be questions about how quickly inflation can reach the Fed's target." She expects that as the market bets on stronger economic growth and inflation, long-term U.S. Treasury yields will climb further.
Last week, Federal Reserve Chairman Powell stated that the 50 basis point rate cut was a "reassessment" of Fed policy, aimed at maintaining a strong job market while inflation moves sustainably toward the Fed's 2% target.
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However, the Fed's repeated emphasis on the resilience of the economy has intensified concerns that the path of rate cuts could be slow and bumpy. The Fed officials' forecasts for interest rates also suggest a slower pace of rate cuts than the market expects.
After the Fed announced the rate cut last Wednesday, the inflation expectations for the next decade, measured by U.S. Treasury Inflation-Protected Securities (TIPS), increased. On Thursday, the 10-year breakeven inflation rate rose to 2.16%, the highest level since early August. On Monday, the index briefly hit a new high of 2.167%.
On Thursday, following the Fed's interest rate decision, the auction of 10-year TIPS was popular among investors, with non-dealers absorbing 93.4% of the $17 billion Treasury sale, the highest level since January. However, according to data from LSEG, the inflow of funds into dollar inflation-linked bonds was negative for the week ending Monday.
Interest rate strategists at BMO Capital Markets said in a report last week: "Investors are once again worried about the specter of reflation." Fund manager Matt Smith of Ruffer said that he has been adding inflation protection to his portfolio over the past few days and weeks.
Many market participants still remember the sell-off caused by the Fed's dovish turn in December last year, followed by unexpected increases in inflation and employment over the next few months.
Although interest rates are still at their highest levels in over 20 years, the Goldman Sachs U.S. Financial Conditions Index, which measures the availability of credit in the economy, has fallen this year. The day after the Fed's decision, the index dropped to its lowest level since May 2022.Brendan Murphy, Head of North American Fixed Income at Insight Investment, stated: "We believe that inflation will remain relatively moderate... but the more the Federal Reserve cuts rates, the more necessary it becomes to question this point."
"Federal Reserve Put Option"
Inflation, as measured by the U.S. Consumer Price Index (CPI), has plummeted over the past two years. In August, it stood at 2.5%, significantly lower than the 40-year peak of 9.1% in June 2022.
Federal Reserve Governor Waller indicated last week that recent data has led him to believe that the Federal Reserve needs to cut rates more quickly, as the inflation rate may fall below the 2% target.
However, reacting to the same information, Federal Reserve Governor Bowman expressed her concern that this more substantial rate cut could be interpreted as "prematurely declaring victory" in the fight against inflation. At last week's meeting, she opposed a 50 basis point rate cut by the Federal Reserve, instead favoring a 25 basis point reduction.
If inflation continues to recede, despite the repricing of the pace of rate cuts bringing volatility, the outlook for bonds may remain optimistic.
But some doubt whether the Federal Reserve's aggressive rate cuts are premature, as the inflation rate is still above target, and recent monthly data suggest that price pressures remain sticky.
Economists at Bank of America Securities mentioned the so-called "Federal Reserve Put Option" in a report last week — the level of the S&P 500 index that would force the Federal Reserve to intervene. They stated that, given the economic resilience and the stock market at historical highs, the "Powell Put Option" has come too early.
"A more aggressive easing cycle could make achieving the 2% target more difficult," they said.
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