Bond traders see crack in Fed’s resolve about inflation

Flattening yield curve in market dominant trend anticipated

NEW YORK: 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 US 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% 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 US 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 rea- son to abandon bets on a December rate hike.

The implied probability of an increase next month is more than 90%, 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?

One thing is for sure, the Fed is more data-dependent than ever, and the key data are inflation. Chris Rupkey