Bond Traders Brace for Inflation Data That Could Rattle the Fed

  • This week’s CPI data is the last before Fed’s December meeting
  • Morgan Stanley sees a risk that rate hike odds fall to 50%
Nobel Laureate Phelps on Inflation and Fed Policy

In the eyes of Morgan Stanley, bond traders would be wise to remember the 15th of November.

That’s when the Labor Department releases October inflation data, the final reading of the consumer price index before the Federal Open Market Committee begins its two-day meeting next month. Officials are widely expected to raise interest rates again, with the market pricing in a more than 80 percent probability of a December hike. Two-year Treasury yields are the highest since 2008 in anticipation of the move.

After Federal Reserve officials for years tip-toed around the Treasuries market for fear of rattling traders with tightening monetary policy, they’ve stuck to their predicted course throughout 2017. So much so, in fact, that a December hike has been a foregone conclusion for weeks, helping compress yield curves in the $14.3 trillion market to the flattest in a decade.

To Matthew Hornbach, global head of interest-rate strategy at Morgan Stanley, the inflation gauge has “game-changing potential,” and is one of the last chances to blow up those well-established trades.

“If U.S. CPI misses, I think the probability of a December hike could head toward 50 percent,” Hornbach said. Whether it gets there depends on how weak it is compared to forecasts, and whether Fed officials express concern about it during their speeches, he said. It could re-steepen U.S. yield curves.

The CPI report for September showed weaker-than-expected price gains even with the disruption wrought by hurricanes. The core measure that strips out volatile items like energy and food prices has remained stubbornly below 2 percent since April, and the consensus estimate is that the report for October will show it holding steady at 1.7 percent.

Fed Rhetoric

The caveat about Fed speakers is important. Even with Chair Janet Yellen admitting stubbornly low inflation is a “mystery,” officials have said price growth below their 2 percent target is “transitory” given the strength of the labor market.

And after all that time spent in the past ratcheting up rate-hike rhetoric to convince traders, policy makers may want to avoid fueling doubts about a December hike now.

“The market has really bought into the Fed’s message -- it would be pretty damaging to about-face just because of a weak inflation print a month before the next meeting,” said Tom Simons, senior money-market economist at Jefferies LLC. That said, “if that CPI print comes in negative for whatever reason, the fed fund futures pricing is going to be a lot lower.”

The next two-day Fed meeting is scheduled to get underway on Dec. 12, with November CPI figures due out the following morning and the U.S. central bank’s official policy announcement a few hours after that.

What to Watch This Week

  • The benchmark 10-year Treasury yield starts the week near the 2.4% level that investors have pointed to as crucial for the direction of the bond market
  • Donald Trump wraps up his first official trip to Asia as U.S. president
  • In Washington, Republicans in the House and Senate continue to push forward with plans to design tax-overhaul legislation
  • The following economic data are scheduled for release, with numbers in the middle of the week most in focus:
    • Nov. 13: Monthly budget statement
    • Nov. 14: NFIB small business optimism index and producer price index
    • Nov. 15: CPI and core CPI, real average weekly and hourly earnings, the Empire manufacturing gauge, retail sales, business inventories, MBA mortgage applications, and Treasury international capital flows data
    • Nov. 16: Initial jobless claims, continuing claims, import and export price indexes, industrial production, capacity utilization, NAHB housing market index, Bloomberg consumer comfort
    • Nov. 17: Housing starts and building permits
  • And the Fed speaking circuit is in full swing:
    • Nov. 14: Yellen will take part in a panel at a European Central Bank event in Frankfurt along with peers from Europe, Japan and the U.K., and Chicago Fed boss Charles Evans will also be at the conference. James Bullard and Raphael Bostic are due to attend events in the U.S.
    • Nov. 15: Evans speaks again, this time in London
    • Nov. 16: Lael Brainard, Loretta Mester, Robert Kaplan and John Williams are all due to speak
  • Apart from bill sales, the week’s only Treasury auction is an $11 billion 10-year TIPS reopening on Nov. 16
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