Wall Street strategists are nearly as divided as possible on whether the Federal Reserve will resume rate hikes next month. One point, however, is undisputed: the U.S. CPI inflation report, set for release on Wednesday, will largely determine the Fed's next move. According to swap market trading, traders currently price in roughly a 50% probability of a 25-basis-point rate hike. After the unexpectedly weak July nonfarm payrolls report, Wall Street has formed an almost perfectly split 50:50 view on whether the Fed will hike by 25bp in September. The Fed under Kevin Warsh has also significantly reduced forward guidance, forcing the market to rely on hard data to determine the policy path. Consequently, the impact of July's CPI is distinctly asymmetric—a mild inflation reading could further weaken the case for a rate hike, but a hotter-than-expected number would more readily re-establish a September hike as the baseline scenario.
For the 10-year U.S. Treasury yield, often called the "global risk-free rate," the risk-reward in the bond market is now heavily skewed toward a "mild July CPI driving yields sharply lower" scenario. This is primarily due to a positive resonance forming between macroeconomic data and the positioning structure of commodity trading advisors. The bond market currently exhibits a dangerous convexity signal, or positioning amplifier: data compiled by UBS shows that CTA funds' underweight in bonds at the end of July had expanded to three times the level seen two weeks prior. Each 1bp move in the 10-year yield now impacts CTA portfolio profit and loss by about $3 billion, the highest level since records began in 1990. Therefore, if core CPI hovers in the 0.15%–0.20% range, the market would not only lower the probability of a September hike but could also trigger a mechanical feedback loop: "yields fall—CTAs stop out and cover bonds—yields fall further." A sustained decline in the 10-year yield, a key benchmark, would be a major positive catalyst for global risk assets like equities, which are currently on the offensive.
Inflation Data Takes Over the Market Narrative, CPI Becomes the Key to September's Rate Decision
Molly Brooks, a U.S. market rates strategist at TD Securities, stated that if inflation data significantly exceeds the market consensus, the probability of a Fed rate hike could rise substantially. Conversely, another mild inflation reading would give policymakers more room to wait. "We believe this data is crucial for September," Brooks said. She added that the market reaction is likely asymmetric—a higher-than-expected reading would have a much greater impact on raising hike probabilities than a lower-than-expected reading would have in reducing them. The consensus among economists is for core CPI to rise 0.2% month-over-month, following a surprising 0.4% decline in the prior reading. Bloomberg Economics forecasts that July's core CPI year-over-year growth will slow to 2.4%, potentially reaching its lowest level since March 2021. Ahead of the U.S. market open on Wednesday, Treasury prices were little changed as the market awaited the inflation report. The benchmark 10-year yield fell 1 basis point to 4.68%, while the 30-year yield dropped to 5.23%. As the chart shows, swap market traders have heavily positioned to price in the Fed's next move. Some U.S. Treasury traders believe the market's pricing of hawkish Fed policy has exceeded what economic fundamentals can support, betting that the upcoming data will force a reassessment. Ruben Hovhannisyan, a fixed-income portfolio manager at TCW Group, said, "We expect a bull steepening of the yield curve as extreme hawkish pricing at the front end is unwound." He added, "Our overweight positions are concentrated at the front end of the curve."
Recent data, however, illustrates how quickly the economic picture can shift. The previous month's CPI report, showing the first decline in inflation since 2020, caused the two-year Treasury yield to drop 14 basis points. Last week's employment report, which showed a surprise reduction in jobs by U.S. employers in July, prompted traders to further lower their expectations for a rate hike this year. In a note last Friday, Goldman Sachs rates strategists said the slowdown in job growth "may have raised the bar that core CPI needs to clear" for a September hike to "be clearly seen by the market as the most likely outcome." Over the past few weeks, several Fed policymakers, including Dallas Fed President Lorie Logan and Minneapolis Fed President Neel Kashkari, have publicly warned that acting too late on inflation could necessitate more aggressive policy measures later. Kelsey Berro, a portfolio manager at J.P. Morgan Asset Management, said, "The real story now is inflation, not the labor market." She noted, "This is an unusual situation—the economy is still expanding, but core PCE is running significantly above all other indicators." Berro stated that the current pricing at the front end of the yield curve for a potential rate hike is reasonable. A July CPI reading significantly above consensus would increase the likelihood of a September hike and further fuel bets on near-term tightening. With Fed Chair Kevin Warsh trying to reduce the central bank's forward guidance, breaking from the recent practice of pre-signaling policy intentions, the importance of economic data has risen sharply again. After the Fed held rates steady last month, long-term Treasury yields surged to their highest levels in nearly 20 years. Bilal Hafeez, founder and head of market strategy at Macro Hive, said, "The market is telling the Fed it has an inflation problem, but the Fed's current view is that recent data is soft enough to not require a rate hike." "Given the extreme negative positioning and the significant rise in yields this quarter, long-duration bonds may offer a more attractive risk-reward for a tactical rebound, even as the long-term bearish outlook for Treasuries remains unchanged," said Ven Ram, a cross-asset strategist at Bloomberg. George Catrambone, head of fixed income at DWS Americas, said he expects the CPI report to provide a clearer indication of the Fed's future policy path than the Jackson Hole symposium later this month. "It's a high bar for another negative headline CPI reading, but after the weak payrolls data, a core CPI reading below 0.2% MoM should be enough to keep the Fed on hold," Catrambone said. "The market may find it hard to understand Warsh, but data should be more convincing than any hawkish or dovish rhetoric at Jackson Hole." DWS prefers holding two- to five-year Treasuries, as the firm does not expect a rate hike from the Fed this year. Catrambone added, "The yield curve from the federal funds rate to two- and five-year notes is quite steep, making this segment look very attractive."
Record CTA Shorts Meet Cooling Inflation: Bond Market Could Become a New Catalyst for Global Risk Assets
The 10-year yield, hovering around 4.68% before the CPI release, already prices in a significant amount of "higher for longer, a possible resumption of hikes, a fiscal term premium, and oil price risk." Goldman Sachs believes that while June's extremely weak CPI had some accidental elements, the diminishing pass-through of tariffs, the fading impact of some geopolitical shocks, and reduced AI-related statistical effects should lead to a gradual softening of monthly inflation in the future. The biggest upside risk remains oil prices. Data compiled by UBS shows that CTA funds' underweight in bonds at the end of July was three times larger than two weeks prior. Each 1bp move in the 10-year yield impacts the profit and loss of CTA strategies, known as "fast money," by about $3 billion, the highest since records began in 1990. So, if core CPI is in the 0.15%–0.20% range, the market would not only reduce the probability of a September hike but could also trigger the mechanical feedback: "yields fall—CTAs stop out and cover bonds—yields fall further." A sustained decline in the 10-year yield, often called the "global risk-free rate," would be a major positive catalyst for global equities currently on the offensive. A sustained decline in Treasury yields is particularly important for global stock markets that are trying to rally again. This is because the CPI report to be released tonight determines not just the market's outlook for the Fed's policy path, but whether the risk-free discount rate in global equity valuation models will continue to rise or will experience a turning point. U.S. stocks have just experienced a strong rebound: in the week ending August 7, the S&P 500 rose 3.58% and the Nasdaq rose 5.19%, with the S&P hitting a new all-time high. Meanwhile, 85.1% of the 436 S&P 500 companies that have reported earnings have beaten expectations, suggesting the market is not solely reliant on valuation expansion but has strong earnings as a fundamental support. Therefore, if tonight's reading shows a "core CPI significantly below 0.2% + weakening employment but earnings not collapsing," it would almost perfectly align with the market's preferred Goldilocks pricing scenario: a decline in the 10-year yield, reduced equity risk premium pressure, a higher present value of long-term cash flows, valuation repairs for high-duration AI tech, software, small-cap growth, REITs, and Asian emerging markets, while the narrowing interest rate advantage of the U.S. dollar further improves global financial conditions. If core CPI is below about 0.2%, global stock markets could experience a rare "triple boost" from fundamentals, policy expectations, and technical positioning. If it is significantly above 0.25%, the 10-year yield, acting as the "global risk-free rate," would re-tighten global financial conditions and subject risk assets, which have just recovered to near historical highs, to a real valuation stress test. Theoretically, the 10-year yield is the risk-free rate (r) in the denominator of the DCF valuation model for stocks. If other metrics, particularly cash flow expectations in the numerator, remain largely unchanged during earnings season, leaving a vacuum of positive catalysts, a higher or persistently elevated denominator level could precipitate a collapse in valuations for AI-related tech stocks, high-yield corporate bonds, and cryptocurrencies, which are already at high valuations. The latest scenario analysis from J.P. Morgan's trading desk shows that if core CPI is 0.15%–0.20%, the S&P 500 could rise by about 0.5%–1%. Even in the base case of 0.20%–0.25%, they still expect a rise of about 0.25%–0.75%. However, J.P. Morgan expects the S&P 500 to fall by about 0.5%–1.25% if core CPI is in the 0.25%–0.30% range. This is why the biggest potential market event from this data may not be the CPI itself, but rather the combination of "cooling inflation + unwinding of hawkish pricing + record bond short covering" creating a rapid global financial conditions easing.
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