(Bloomberg) — Bond traders and Federal Reserve Chairman Kevin Warsh are in agreement on a crucial point: The central bank’s fight against inflation still seems far from over.
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The Labor Department report that US consumer prices in June saw the first monthly drop since 2020 was met with relief in financial markets, where investors last week rapidly unwound bets that the central bank might start raising interest rates later this month.
But it was likely just a temporary reprieve. Oil prices are rising again after the US-Iran ceasefire collapsed. A flood of artificial-intelligence spending is continuing to plow stimulus into the economy even as bubble fears hit some tech stocks. And Warsh, who took over as Fed chief two months ago, has made it clear that the central bank’s priority is to pull down inflation that’s been stuck above its 2% annual target for the past five years.
As a result, traders are still anticipating that the Fed is almost certain to start increasing its benchmark rate by the end of the year — and potentially as soon as September.
“If you do nothing, are you confident that inflation will return to 2% or 2.5%? The answer is no,” said Ed Al-Hussainy, portfolio manager at Columbia Threadneedle, who is betting that longer-dated bonds will outperform short-term notes, a position that will benefit from a more hawkish central bank. “The Fed should feel more comfortable raising rates without worrying as much about the downside risks.”
The Fed has kept monetary policy steady since its last rate cut in December as the job market rebounded from a February slump and President Donald Trump’s war on Iran hit the global economy with a fresh inflation shock. Both of those shifts dashed once widespread expectations that the Fed would resume cutting rates even as Trump appointed Warsh to replace Jerome Powell, who the president had repeatedly attacked for not lowering borrowing costs more quickly.
Warsh has since signaled that he’s eager to maintain the Fed’s political independence and won’t cave to Trump’s pressure.
During his first post-meeting press conference as chairman last month, Warsh focused repeatedly on the need to bring down inflation. He underscored the message again last week on Capitol Hill, where he said the June consumer price index figures didn’t mean the Fed’s mission had been accomplished. Three other regional Fed bank presidents — Jeff Schmid, Lorie Logan and Beth Hammack — struck a similar tone.
While traders now see little chance of a July rate hike, they’re still putting high odds on a quarter-percentage-point increase in September or October, with such a move seen as all but certain by December.
Even so, the impact on financial markets may be relatively muted, given that US Treasury yields have already risen sharply in anticipation. Since the end of February, the rate on two-year Treasuries has jumped by about three quarters of a percentage point to nearly 4.2%, well above the 3.5%-3.75% band on the Fed’s rate.
The broad rise in such Treasury yields has, in turn, pushed up the costs of mortgages and other types of loans, doing some of the Fed’s work by tapping the brakes on the economy.
“The market is pricing a more hawkish path for the Fed than what we are expecting if we are right about the trajectory of lower inflation and moderating growth during the second half of the year,” said Chi Chen, co-manager of BlackRock Inc.’s $18 billion Total Return Fund. “The Fed is likely to remain in a hawkish space and wait for the data to eventually moderate.”
As a result, her firm is favoring intermediate-maturity bonds and shorter-dated ones whose yields rose during the post-Iran-war selloffs. “Valuations are definitely more attractive than before.”
Warsh hasn’t tipped his hand on when the Fed is likely to act and favors dialing back the central bank’s guidance on where rates are headed, given the risk it can leave policymakers boxed in and hesitant to change course. And there will be little new data or comments this week by Fed officials, who are going into their usual blackout ahead of the two-day meeting that starts on July 28.
What Bloomberg Strategists Say…
If the Fed cannot get them down, its inflation-fighting nous won’t bring dividends for investors. With the yield curve continuing to steepen and long-end real yields not declining, Tuesday’s Treasury rally still looks ominously like a relief rally.
—Edward Harrison, strategist, Markets Live. For the full analysis click here.
Bank of America Corp.’s economists expect the Fed to hike at the September, October and December meetings. After the June consumer price index figures were released, they said in a note to clients that with inflation still well above the Fed’s target “we would need to see a couple more prints like this to rethink our current call.”
The lack of clarity favors taking a cautious stance by not piling into positions that are heavily affected by Fed moves, said Al-Hussainy, the fund manager at Columbia Threadneedle.
“It’s not the time to stick your neck out,” he said.
What to Watch
Economic data:
July 20: Leading index
July 21: ADP weekly employment change; Philadelphia Fed non-manufacturing activity
July 22: MBA mortgage applications
July 23: Initial jobless claims; Chicago Fed national activity index; Kansas City Fed manufacturing activity
July 24: Bloomberg July US economic survey; S&P Global US manufacturing, services and composite PMIs; new home sales; Kansas City Fed services activity; building permits
Fed calendar:
Auction calendar:
July 20: 13-, 26-week bills
July 21: 6-week bills
July 22: 17-week bills; 20-year bonds
July 23: 4-, 8-week bills; 10-year Treasury Inflation Protected Securities
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