Bond Traders Eye Inflation for Rate Clues as Recession Odds Fade
(Bloomberg) -- The temporary US-China trade truce dimmed the odds of a recession and sparked a selloff in Treasuries, raising the stakes for investors ahead of the release of inflation figures for the world's biggest economy.
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With market-implied expectations for Federal Reserve interest-rate cuts receding and a multi-trillion-dollar tax package seen likely to worsen the US government budget deficit, focus is now on Tuesday's inflation data for any signs of a pickup in price pressures. The report will be the first to show tariff-related costs.
'If you have to put a gun to my head and say what's the most likely single view it probably would be that the Fed maintains rates on hold this year because inflation stays pretty elevated,' said Mark Dowding, chief investment officer of BlueBay Fixed Income.
According to Fed Governor Adriana Kugler, even with the 90-day levy reduction on Chinese goods, President Donald Trump's tariff policies risk sparking a rise in inflation and unemployment.
Consumer prices for April are forecast to show the annual pace of growth held the same as the month prior, according to estimates compiled by Bloomberg. Core inflation is forecast to remain at a 2.8% level.
The new tariff levels will translate into a 1.5% hit to US GDP and 0.9% boost to core PCE over a period of two to three years, about half the shock predicted before the US-China talks, according to Bloomberg Economics.
Goldman Sachs said Monday that it now expects three quarter-point rate cuts starting in December instead of July, with just a 35% probability of a recession versus 45% previously. Citigroup economists also pushed back their prediction for the Fed's next rate cut to July from June after tempering of US-China tariffs.
Swaps traders, who had previously seen rate cuts as early as June, are now pricing in the first full Fed quarter-point rate cut in September, with just slightly more than two full reductions seen through year end.
'Right now the market pricing-in two Fed rate cuts seems to be sort of a fair probability rating assessment,' said Dowding.
Since the end of April, US government bonds have slumped, pushing yields across all maturities higher. Benchmark 10-year yields trade at 4.47%, well above the lows of this month of 4.12%. Policy sensitive two-year yields have risen nearly 40 basis points to hover now at just under 4% — jumping about 12 basis points on Monday alone.
Dowding said he is looking to purchase 10-year Treasuries if yields move back to 4.8% — around the peak level of 2025 reached in mid-January — and sell them if rates fall below 4.2%
Despite the administration touting they can extend Trump's 2017 tax cuts without worsening the US deficit, market participants are less clear that will pan out. The plan announced Monday will take a big step toward advancing through the House as soon as this week, with the House Ways and Means Committee scheduled to begin debate on it Tuesday.
Economists at Deutsche Bank in a note earlier this month said the final package will likely keep the US deficit-to-GDP level stuck near 6.5% for the next few years.
'If you look at what's coming down the road out of Washington, the administration is talking about Independence Day for the tax package,' said Gregory Faranello, head of US rates trading and strategy for AmeriVet Securities. 'So the Fed is going to wait that out,' as well as move slowly to monitor economic data.
Faranello also sees rising Treasury yields as providing good opportunities to purchase more debt as he expects the labor market to crack and the Fed cutting rates sometime in the second half of the year.
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