Fed Rate-Hike Bets Mount Before Inflation Data, Warsh Testimony

(Bloomberg) — Bond traders ramped up bets for a July interest-rate hike ahead of US inflation data and an appearance by the head of the Federal Reserve that stand to reinforce the need for action.

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Rising rate expectations are evident both in interest-rate options, where the market-implied chance of a quarter-point hike later this month has climbed to about 50% from less than 10%, and in US government bonds. The two-year Treasury note’s yield, more sensitive than longer-maturity debt to changes in the Fed’s rate, stayed above 4.25% Tuesday, exceeding the policy rate by a widening margin.

“July is live for a hike,” said Ed Al-Hussainy, portfolio manager at Columbia Threadneedle, who sees an increase as likelier than not. Although the inflation rate targeted by the Fed was somewhat lower than the consumer price index in May, at 4.1%, “we are going to need some luck to get the numbers drifting back to 2%.”

The moves accelerated after Fed Governor Christopher Waller — until recently one of the central bank’s most dovish officials — said a rate increase “in the near term” should be considered if the inflation data show “another hot reading” on core prices, which exclude food and energy.

June consumer price index data to be released Tuesday at 8:30 a.m. in Washington are anticipated to show the first declines in the overall and core inflation rates since January, according to the median forecasts in a Bloomberg survey. Those rates were 4.2% and 2.9% in May.

Still, bond traders are increasingly anxious it will take higher interest rates to bring inflation back toward the Fed’s 2% target. Oil prices extended gains on Tuesday, with US military forces set to resume blockading traffic to and from Iranian ports and coastal areas. Trump also said the US would keep up attacks on Iran.

Their stress is compounded by Fed Chairman Kevin Warsh’s aversion to making predictions about its course. Warsh, who took office in May, is slated to testify before Congress Tuesday and Wednesday on the central bank’s semiannual report on monetary policy.

Short-term interest-rate markets fully price in a Fed rate increase by year-end and a second one by mid-2027 — probably not enough, Al-Hussainy said. He thinks the central bank is likely to unwind all three of the quarter-point cuts it made over the final four months of last year in response to weakening labor-market conditions.

Those probabilities have increased since Warsh, speaking at the European Central Bank’s symposium in Sintra, Portugal on July 1, highlighted recent declines in inflation risks.

Wagers on near-term Fed rate hikes have flooded into the interest-rate futures market, helping drive up open interest in August federal funds futures. The number of contracts in which traders hold positions has increased about 23% in July. Open interest data are reported after the close, and stand to increase further based on Monday’s trading activity.

The CPI report is expected to show a 0.1% drop in overall prices from May, bringing the year-on-year rate down to 3.8% from 4.2%. Core prices are seen rising 0.2% from May and 2.8% from last June.

Even softer-than-expected CPI readings may provide limited relief in the bond market, however, where two-year Treasury yields have risen about 10 basis points this month, 10-year yields 15 basis points, wiping out the market’s gains for the year as measured by the Bloomberg Treasury index.

“Investors remain focused on the July 29 FOMC meeting as potentially the timing for Warsh’s first rate hike,” Ian Lyngen, head of US rates strategy at BMO Capital Markets, wrote in a note.

While he expects the market’s conviction in a July rate hike to decrease based on June CPI data and Warsh’s testimony this week, Warsh’s disdain for forward guidance should limit how much.

The market may continue to price in at least some chance of a July rate hike even if the CPI data are soft, and the Fed could surprise investors by raising rates even if that outcome isn’t close to fully priced in, Lyngen said.

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