December rate cut calls build following in-line inflation data

Traders added to wagers that the Federal Reserve will cut interest rates by another quarter point next month after in-line inflation data, spurring gains for Treasury debt.

The rally trimmed yields on two-year notes, more closely tied to Fed rate decisions than longer tenors, by as much as 10 basis points to 4.24%. Global benchmark 10-year yields declined about seven basis points to 4.30%. Yields remain near the highest levels in months, reached in the week since the election of Donald Trump, whose tax policies have been predicted to be inflationary.

The October consumer price index data quelled concern about halting progress toward lower inflation even before Trump takes office in January. Bond traders in the weeks leading up to the Nov. 5 election — which pollsters said was too close to call — had lowered their expectations for additional Fed rate cuts over the coming year. 

Swaps traders boosted to about 80% the probability that the Fed will cut rates again on Dec. 18, up from around 56% earlier Wednesday. Through June, they priced in nearly 62 basis points of cumulative reductions.

“Bang in-line core inflation leaves the Fed on track to cut rates in December,” said Lindsay Rosner, head of multi-sector fixed income investing at Goldman Sachs Asset Management. “After a run of unseasonably hot autumn data, today’s number cools fears of an imminent slowdown in the pace of rate cuts.”

Consumer prices rose 2.6% year-on-year in October overall and 3.3% excluding the volatile food and energy categories. Both figures matched the median forecasts of economists in a Bloomberg survey. The figures underscore the slow and frustrating nature of the battle against inflation, which has often moved sideways — sometimes for months at a time — on its broader path down.

Before the CPI data, traders had been piling into bets that the Trump agenda would lead to further losses in Treasuries. Open interest — the number of contracts in which traders have positions — in Treasury futures suggests an increase in new hedges for higher yields since the election.

Wednesday’s Treasury futures activity after the data included a couple of large block trades in the five-year note contract that appeared to contribute to the rally.

Fed policymakers have been delivering the message that — after their initial half-point rate cut in September and a quarter-point reduction on Nov. 7 — future moves are contingent on inflation continuing to show improvement.

Two officials echoed that after the CPI data were released Wednesday. Minneapolis Fed President Neel Kashkari, speaking on Bloomberg Television, said he views inflation as “heading in the right direction” but the December decision would take into account future economic data.

Dallas Fed President Lorie Logan said the Fed should “proceed cautiously at this point” because of the risk inflation remains elevated. 

Trump’s agenda — which includes tax cuts — is seen expanding the federal budget deficit, requiring increased US debt issuance. Investors are accordingly demanding higher Treasury yields as the price of providing additional financing. Some have predicted 10-year yields will return to 5%, reached in late 2023 for the first time since 2007 as Treasury supply increased.

Many of Trump’s ideas “are pro-growth policies, though having said that, the wild card is tariffs,” said Earl Davis, head of fixed income and money markets at BMO Global Asset Management in a telephone interview. Investors are “still trying to find how much risk premium is needed now – and the market is saying it’s definitely not less.”

Davis expects increased debt issuance next year and favors buying inflation-protected over so-called nominal Treasury debt. The 10-year TIPS yield is about 2.1%, up from as low as 1.5% in mid-September, a period in which the nominal 10-year yield climbed about 80 basis points as inflation expectations increased.