Bond Traders Start to See Crack in Fed's Resolve About Inflation

  • Chair nominee Powell among officials set to appear this week
  • Commitment to rate hikes has been key to flatter yield curve
Mainstay Capital Management’s David Kudla discusses the Fed’s policy path in 2018 and inflation.

Traders are about to find out just how worried Federal Reserve officials are about the outlook for inflation. The depth of that angst has ramifications for the U.S. bond market’s dominant trend: the flattening yield curve.

Fed Chair Janet Yellen and the nominee to succeed her, Jerome Powell, lead a busy lineup of central bankers speaking this week. They may opine on inflation after minutes of their most recent meeting published last week showed several policy makers were concerned about low expectations for consumer-price gains and underscored that further interest-rate hikes will hinge on economic data. It’s only fitting, then, that the Fed’s preferred gauge of price growth will also be released this week, with a survey of economists indicating it’s likely to slow to a 1.5 percent year-on-year pace.

For the bond market, the expectation of further rate hikes amid below-target inflation has big implications. It’s been perhaps the key reason why the U.S. curve has flattened in the past month at the fastest pace in nearly three years. That compression has already elicited responses from some Fed officials, and investors will be attuned to any indications from Powell or Yellen about how that might affect their thinking. After the minutes, traders may question the Fed’s resolve anew, pondering whether they were wrong to push two-year Treasury yields to the highest level since 2008.

“We are starting to become afraid that a few Fed inflation scaredy cats will grow to many more Fed officials next year if core PCE inflation does not start showing some signs of moving up,” Chris Rupkey, chief financial economist with MUFG Union Bank in New York, wrote in a note Nov. 22. “One thing is for sure, the Fed is more data-dependent than ever, and the key data are inflation.”

The bond market isn’t going as far as taking the latest fretting among policy makers as reason to abandon bets on a December rate hike. The implied probability of an increase next month is more than 90 percent, based on overnight index swaps and the effective fed funds rate. But investors are once again tempering their enthusiasm about the central bank’s ability to stoke consumer prices in the longer term, with so-called breakeven rates on inflation-linked bonds dipping. The dollar’s fledgling rally also came to a halt with the currency dropping to an almost two-month low after Yellen cautioned about allowing inflation to drift lower.

Yellen and Powell will both be in Washington this week. Yellen goes before the Joint Economic Committee of Congress, while Powell appears at the Senate Banking Committee as part of his confirmation process.

Since the Fed’s Nov. 1 decision, the yield curve from two to 10 years has flattened by 15 basis points and is now close to the lowest level in a decade. Fed officials including James Bullard and Robert Kaplan have given their views on the trend in the curve since then and they’re on tap to speak again this week. Traders will monitor all of these speakers with one question in mind: after a year in which the Fed has largely stuck to its script, will inflation drive policy makers to improvise?

What to Watch This Week

  • The following economic indicators are scheduled for release:
    • Nov. 27: New home sales; Dallas Fed manufacturing activity
    • Nov. 28: Wholesale and retail inventories; advance goods trade balance; FHFA house price index; S&P CoreLogic Case-Shiller indexes; Conference Board consumer confidence data; Richmond Fed manufacturing index
    • Nov. 29: Second estimate of gross domestic product report for the third quarter, including personal consumption expenditure measures; MBA mortgage applications; pending home sales; Fed’s Beige Book
    • Nov. 30: Personal income and spending report for October, including PCE inflation measures; initial jobless claims; Chicago business barometer; Bloomberg consumer comfort
    • Dec. 1: Markit U.S. manufacturing PMI; ISM manufacturing, prices paid, new orders and employment; construction spending
  • Some outgoing Fed officials set to speak, while the Senate begins its consideration of Jerome Powell as the next chairman
    • Nov. 27: New York Fed boss William Dudley speaks on the U.S. economy post-crisis, while Minneapolis Fed’s Neel Kashkari participates in a forum
    • Nov. 28: Senate Banking Committee holds a hearing on Powell, while Dudley speaks at a conference on the Treasury market and the Philadelphia Fed’s Patrick Harker speaks on financial safety for an aging population
    • Nov. 29: Dudley speaks again about the U.S. economy, Yellen appears before the Joint Economic Committee of Congress, and the San Francisco Fed’s John Williams speaks in Phoenix
    • Nov. 30: Randal Quarles appears in Cleveland to discuss the payments system, Kaplan speaks in Dallas
    • Dec. 1: Bullard speaks in Arkansas, Kaplan speaks again in Texas and Harker speaks on inclusive economic growth
  • Treasury’s auction schedule ramps back up, though it’s compressed given the proximity to month-end
    • Nov. 27: Selling $26 billion of two-year notes and $34 billion of five-year notes, both at 1 p.m. New York time
    • Nov. 28: Selling $28 billion of seven-year notes
  • Tax reform will also be back on the agenda as Congress returns after the Thanksgiving holiday: the Senate Finance Committee last week released legislative text of its tax bill and floor action is expected on the proposals

— With assistance by Jenny Paris

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