US Treasury markets saw modest gains this week, as cooling inflation data boosted market sentiment and offset pressure from a sharp rebound in international oil prices. This led traders to significantly reduce their bets on a Federal Reserve interest rate hike in July. However, surging oil prices and continued hawkish signals from Fed officials mean expectations for another rate hike before year-end persist.
This week's release of US Consumer Price Index (CPI) and Producer Price Index (PPI) data both indicated easing inflationary pressures, driving a broad decline in US Treasury yields. Short-term Treasuries, which are most sensitive to monetary policy, performed best, leading the decline in yields. Nonetheless, the sharp rise in international oil prices limited the bond market's gains, as investors still believe higher energy costs could reignite inflation, potentially prompting the Fed to continue tightening monetary policy later this year.
Molly Brooks, a US rates strategist at TD Securities, noted that following this week's inflation data, the market has clearly reduced expectations for further Fed rate hikes, with the probability of a near-term hike seeing a notable decline. The interest rate swaps market indicates traders now see only about a 15% chance of a 25-basis-point rate hike at the Fed's July 28-29 policy meeting, down from roughly 50% previously. With few significant economic data releases before the meeting and Fed officials about to enter their pre-meeting "blackout period," there is limited room for further adjustment to market expectations for July policy.
Consequently, the yield on the 2-year US Treasury note fell by 3 basis points over the week to 4.18%. However, significant divergence remains regarding the Fed's medium- to long-term policy path. Recently, voices within the Fed supporting further rate hikes have increased, with even some previously relatively dovish officials shifting to a more hawkish stance.
Cleveland Fed President Loretta Mester stated on Friday that persistently high inflation remains her primary concern, given resilient consumer spending and the unemployment rate remaining low. Dallas Fed President Lorie Logan said on Thursday that the US may need "somewhat higher" interest rates, as there is not yet sufficient evidence that inflation can sustainably return to the Fed's 2% target. In fact, both Mester and Logan are already considered among the more hawkish officials within the Fed; they had opposed signaling potential future rate cuts in the April policy statement.
Simultaneously, escalating tensions in the Middle East have re-elevated risk premiums in energy markets. This week, a new round of US military strikes against Iran triggered sharp volatility in international oil prices. US West Texas Intermediate crude futures settled at $82.49 per barrel on Friday, posting a weekly gain of nearly 16% and reaching its highest closing level since June 12.
While recent improvements in US inflation data have weakened expectations for a near-term rate hike, the combination of rebounding energy prices and continued hawkish rhetoric from Fed officials suggests that market bets on another rate hike within the year have not completely dissipated. The future path of Fed policy will continue to depend on the trajectory of inflation and energy price movements.
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