Economy

Analysis: Fed’s Significant Rate Cut Revives ‘Reflation Specter’ in US Bond Market

By Davide Barbuscia

NEW YORK – The Federal Reserve’s swift initiation of an easing cycle has reignited concerns about inflation in the U.S. bond market, with some investors apprehensive that more lenient financial conditions could lead to renewed price pressures.

Yields on longer-dated Treasuries, which are particularly responsive to the inflation forecast, have surged to their highest levels since early September. This increase has raised concerns among investors that the Fed’s shift in focus—from combating inflation to prioritizing job market stability—may allow for a resurgence of inflationary pressures.

"I think there are questions around how quickly inflation will reach the Fed’s target in a cutting environment, especially if the Fed suggests supporting the labor market before it weakens," remarked Cayla Seder, a macro multi-asset strategist. She anticipates that long-term yields, which increase when bond prices decline, will continue to rise as markets predict stronger growth and inflation.

Federal Reserve Chair Jerome Powell indicated last week that the 50 basis point interest rate reduction that marked the beginning of the bank’s easing strategy was a "recalibration" aimed at sustaining labor market strength while guiding inflation back to the Fed’s 2% target.

The Fed’s focus on economic stability has led to worries that reducing rates may not be a straightforward process. The forecasts from Fed officials also imply a more gradual approach to rate cuts than what many market participants had expected.

Expectations for inflation over the coming decade, as reflected in Treasury Inflation-Protected Securities, rose following the Fed’s announcement. The 10-year breakeven inflation rate increased to 2.16%, the highest level since early August, peaking at 2.167% on Monday.

An auction of 10-year TIPS held after the Fed’s rate-setting meeting attracted strong interest, with non-dealers purchasing 93.4% of the $17 billion Treasury debt offered, marking the highest share since January. However, flows into U.S. dollar inflation-linked bonds were negative in the week ending Monday.

"Investors are once again worried about the potential for reflation," noted strategists at BMO Capital Markets. Matt Smith, a fund manager, mentioned he has been incorporating inflation protection into his portfolio recently.

Recent market history is fresh in many minds, recalling a selloff that occurred following a dovish pivot by the Fed in December, which was followed by several months of inflation and employment surprises.

The Goldman Sachs U.S. financial conditions index, which gauges credit availability, has loosened throughout this year even as interest rates remain at their peak for over two decades. Following the Fed’s decision, the index dropped to its lowest level since May 2022.

"We believe inflation will stay relatively tame… however, the more aggressive the Fed cuts, the more that assumption may be called into question," observed Brendan Murphy, head of fixed income, North America, at Insight Investment.

In terms of inflation, the latest Consumer Price Index data showed a notable decline over the past two years, with August’s figure at 2.5%, down from a 40-year high of 9.1% in June 2022.

Fed Governor Christopher Waller expressed last week that recent data strongly indicated the need for faster rate cuts to avoid falling short of the 2% inflation target. Conversely, Fed Governor Michelle Bowman voiced concerns that significant cuts could be seen as "a premature declaration of victory" over inflation. She opposed the half-percentage-point cut last week, advocating instead for a quarter-percentage-point reduction.

If inflation continues to diminish, the outlook for bonds could remain favorable, despite the volatility associated with adjusting the pace of interest rate cuts. Nonetheless, some analysts wonder if the central bank’s aggressive move was premature, given persistent inflation above the target and recent signs of resilience in price pressures.

Economists from BofA Securities remarked that the perceived "Fed put"—the idea that the central bank will support financial markets—might have come too early, especially with ongoing economic strength and the stock market at all-time highs. "A more aggressive easing cycle could complicate the path to achieving the 2% inflation target," they cautioned.

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