Inflation Risks Threaten Fed Rate Cut Expectations

Bond investors wagering on a Federal Reserve rate cut next month are confronting a potential hurdle: inflation. Tuesday's release of the July Consumer Price Index (CPI) will provide traders with insights into how the Trump administration's tariff policies are impacting costs. A Bloomberg survey of economists predicts that the core inflation rate will rise to 3%, the highest level since February. "The market is seeking further confirmation on whether trade policy adjustments have translated into higher goods inflation," says Gennadiy Goldberg, head of U.S. rates strategy at TD Securities. "All else being equal, a higher inflation print would likely make the Fed want to see more data before moving forward with a rate cut." This could disappoint investors who are betting the Fed will cut rates twice by year's end, with the first cut as early as September. Signs of a weakening U.S. job market have reinforced their conviction that the time is right for the first rate cut since last December. U.S. Treasury yields have already fallen to late-April levels, and a U.S. Treasury total return index is up 4% this year, on track for its best annual performance since 2020.

Market Expectations and Hedging Against Risks

Since the weak July non-farm payrolls report, bond traders in the options market have been positioning themselves for a deeper and more sustained path of rate cuts in the coming months. Investors have been actively betting that the Fed is likely to cut rates by 25 basis points at its September 17 meeting. Meanwhile, options trading linked to the overnight secured financing rate (SOFR), which closely tracks the expected path of U.S. monetary policy, showed on Monday that some investors are preparing for "inflation data that gives the Fed a reason to cut rates by 50 basis points."

Stagflation Concerns and the Impact on the Dollar

However, the risk of rapidly rising prices is a concern for Federal Reserve Chairman Jerome Powell, as well as some figures on Wall Street. Bank of America, Apollo Global Management, and Bank of New York Mellon have all listed stagflation as a major concern in recent reports. Stagflation, which is high inflation coupled with weak economic growth, also poses a risk to the U.S. dollar – which has already depreciated nearly 8% this year against a basket of currencies. TD Securities strategists said on Monday that a dollar decline would accelerate in a stagflation scenario. Sticky inflation would weaken the Fed's ability to cut rates to the "roughly 3% priced into the swaps market" over the next 12 months and could also push U.S. Treasury yields higher. U.S. Treasury yields rose last week, as three weak auctions reflected softer demand for U.S. government debt ahead of the CPI report.

Diverging Views on Fed Strategy

"If inflation continues to rise in July, it would validate Powell's statement that the 'Fed's dual mandate (full employment and price stability) is in conflict,'" says George Catrambone, head of Americas fixed income at DWS. Policymakers must also consider the August CPI data and the producer price report released on Thursday before making a decision in September. After the Fed held interest rates steady last month, Powell reiterated that officials need more time to assess the impact of tariffs before cutting rates, suggesting he remains patient amid continued pressure from Trump to cut rates. However, Trump-appointed governors Waller and Bowman dissented, arguing in favor of an immediate rate cut due to weakness in the labor market. JPMorgan Chase says that adding Stephen Miran, the president's economic advisor, to the Federal Reserve Board could add another dovish voice to the decision-making table. Roger Hallam, global head of rates at Vanguard Asset Management, anticipates that unless inflation is significantly higher than expected, policymakers will focus on signs of instability in the labor market. "Ultimately, barring an extreme inflation scenario, the Fed will prioritize the labor market," he said. He stated that the labor market has shown enough weakness, "making a rate cut in September very likely."