(Bloomberg) -- Traders boosted expectations for a Federal Reserve interest-rate hike after hotter-than-expected core US inflation data, with a 90% chance of a move next week and two increases fully priced in by year-end.
Interest-rate swaps showed traders ramped up bets on higher benchmark rates in the months ahead, with sticky price pressures seen pushing policymakers led by Fed Chairman Kevin Warsh to act. Treasuries initially dropped, then rebounded on Friday.
"The Fed is behind the curve," said David Rees, head of global economics at Schroders Plc. "The Fed can either choose a rate hike next week and a controlled rise in short-term US borrowing costs, or do nothing and risk an uncontrolled rise in long-term US borrowing costs."
The consumer price index, excluding food and energy, rose by a greater-than-expected 0.3% in August from a month earlier, according to Bureau of Labor Statistics data out Friday. On an annual basis, it advanced 2.4%.
Yields on two-year notes, the most reactive to Fed policy, rose as much as seven basis points to 4.66%, the highest since 2024, before wiping out that move. Yields on 10-year securities fell five basis points to 4.91%, after earlier touching 4.98% earlier. The outperformance of inflation-sensitive longer-dated bonds showed traders expect the Fed to tighten policy, slowing growth and cooling price pressures over time.
The Treasury market's muted reaction follows its second-worst day this year, when a surge in oil prices helped drive yields to multiyear highs. Traders said Thursday's selloff anticipated the prospect that the CPI data would cement the case for a September rate increase. That served to limit market reaction to the data Friday.
The Bloomberg US Treasury Index fell 0.6% Thursday, its worst day since March 20, when rising oil prices helped drive a rout in UK government bonds.
Still Above Target
The report suggests inflation is making little progress toward the Fed's goal amid soaring energy costs from the Iran war, tariffs and the data center buildout. Warsh has been reluctant to tip his hand on the central bank's next move, but in a speech last month he said the Fed would "have work to do" if inflation doesn't cool "at sufficient speed."
"This would not seem to meet Chair Warsh's criteria for getting inflation back to 2%," said Win Thin, chief economist at Bank of Nassau 1982, who expects a hike next week. With traders almost fully pricing an interest-rate increase, "the market is forcing the Fed's hand," he said.
Treasuries, along with global bond markets, have been hit in recent months as renewed hostilities in the Middle East pushed Brent crude above $100 a barrel and worries about fiscal spending and deficits remained a concern.
The 10-year Treasury yield has climbed 14 basis points this week, trading just below the psychologically important 5% level, which it has reached only once since 2007. Germany's 10-year yield touched its highest since 2009 after the European Central Bank raised interest rates for the second time since the war broke out in late February.
'Clears the Path'
The CPI report, coming just days before next week's Fed meeting, was seen as removing a key obstacle to a rate increase. Governor Christopher Waller said last week that his decision would be "heavily influenced" by this week's inflation data.
"The report clears the path for the FOMC to hike next week — a move that we expect will be followed by at least an additional quarter-point by year end," wrote Ian Lyngen, head of US rates strategy at BMO Capital Markets. "The front end cheapened while duration has rallied in outright terms. The price action makes sense — Fed credibility is compressing forward inflation expectations."
Friday's rally in longer-dated Treasuries offered some relief for Treasury Secretary Scott Bessent, who has struggled to contain the broader bond selloff ahead of the midterm elections. Expanded Treasury bond buybacks this week did little to counteract the trend.
Bessent has sought to downplay concerns about the rise in yields, saying the Treasury market is in "very good shape," pointing to robust demand at recent auctions and highlighting US bonds' performance relative to their global peers. On Thursday, a $22 billion sale of 30-year bonds drew historically strong demand, a sign that higher yields are attracting some buyers.
--With assistance from Edward Bolingbroke and Michael MacKenzie.
(Updates with comment, chart and context throughout. A previous version corrected the move of 10-year yields.)
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