There are signs that the Federal Reserve is actively starting the easing cycle, which is rekindling concerns about inflation in the US bond market, because some investors are worried that the loose financial environment may trigger price pressure again.
As we mentioned earlier this week, the yield of long-term US treasury bond bonds, which are particularly sensitive to the inflation prospect, has recently risen to the highest level since early September. Especially the 10-year US Treasury yield, known as the "anchor of global asset pricing," has risen instead of falling after the Federal Reserve's significant interest rate cuts. Some investors are concerned that the Fed's shift in focus from suppressing inflation to protecting the job market may lead to a rebound in inflation data that has not yet fully returned to the Fed's 2% target.
Cayla Seder, a macro multi asset strategist at State Street Global Markets, said, "I believe that if we are in an environment of interest rate cuts and the Federal Reserve has expressed a desire to support employment more before the labor market weakens, then how quickly inflation can reach the Fed's target will become a question
She expects that as the market bets on economic growth and stronger inflation, long-term bond yields will further climb.
Federal Reserve Chairman Powell stated at a press conference after the meeting last week that the 50 basis point rate cut that marks the start of this round of the Fed's easing cycle is a "readjustment" of interest rates aimed at maintaining a strong labor market while sustainably moving inflation towards the Fed's 2% target. The dot matrix forecast of Federal Reserve officials also indicates that the pace of interest rate cuts will be relatively slower than market expectations.
However, even so, concerns about inflation among bond market traders quickly began to emerge.
The 'inflation ghost' reappears in the bond market
After the Federal Reserve announced interest rate cut last Wednesday, the inflation expectations measured by the US treasury bond inflation protected bonds (TIPS) in the next ten years rose significantly. As of this Wednesday, the 10-year breakeven inflation rate has rebounded to 2.18%, the highest level since early August.
Last Thursday, the US Treasury Department renewed the issuance of US $17 billion 10-year inflation protected treasury bond bonds (TIPS). Investors flocked to it. The allocation ratio of non primary dealers (direct bidders+indirect bidders) reached 93.4%, the highest level since January.
In a report last week, interest rate strategists at BMO Capital Markets stated that "investors are once again concerned about the specter of re inflation
Ruffer fund manager Matt Smith also pointed out that in the past few days and weeks, he has been adding inflation protection to his investment portfolio through commodities and commodity stocks.
He stated that commodities and commodity stocks are typical inflation hedging tools, and their current valuations are extremely low.
Will past tragic experiences reappear?
In fact, many people in the market still have vivid memories of the Federal Reserve's dovish policy shift in December last year, but the subsequent months of unexpectedly rising inflation and employment performance that led to the sell-off.
The Goldman Sachs US Financial Condition Index is an indicator of the availability of economic credit. Although the federal funds rate remained at its highest level in over 20 years for most of this year, the index has declined during the year, reflecting relatively loose financial market conditions. Especially on the second day after the Federal Reserve's September decision, the index fell to its lowest level since May 2022.
Brendan Murphy, head of North American fixed income at Insight Investment, said, "We believe inflation will remain relatively benign... but the more aggressively the Federal Reserve cuts interest rates, the more reason you have to question it
Measured by CPI, the inflation rate in the United States has indeed sharply declined in the past two years. The year-on-year increase in US CPI in August has fallen to 2.5%, far below the over 40 year high of 9.1% set in June 2022. Federal Reserve Governor Waller stated last week that recent data has convinced him that the Fed needs to cut interest rates faster as inflation may fall below its 2% target.
However, Federal Reserve Governor Bauman, who cast the only dissenting vote at the September meeting, expressed concern that a larger rate cut could be interpreted as a "premature announcement" of a successful fight against inflation. She opposes the 50 basis point rate cut by the Federal Reserve last week and supports a smaller 25 basis point rate cut.
Some market participants also doubt whether the Fed's significant interest rate cut is premature, as inflation is still above target and recent monthly data shows some stickiness in price pressures.
In a report last week, economists at Bank of America Securities mentioned the so-called "Federal Reserve put options" - the phenomenon in the past where the Federal Reserve tended to lend a helping hand to financial markets in times of crisis.
Bank of America Securities stated that considering the resilience of the economy and the historically high stock market, the Powell put option came too early this time. They pointed out that a more aggressive easing cycle may make it more difficult to achieve the 2% inflation target