(Bloomberg) -- Bond traders' expectations were bolstered for the Federal Reserve to lower interest rates by mid-year after a weaker-than-expected US inflation reading.
Interest-rate swaps showed traders continued to all-but-fully price in a Fed rate cut by the June policy meeting, with some chance of an earlier move but minimal odds of action this month on Jan. 28. Treasuries, which initially rallied after Tuesday's data, failed to sustain the positive reaction as investors looked ahead to an auction of 30-year bonds later in the session.
"If we cut through the noise, it's a pretty encouraging number," said Dan Carter, a senior portfolio manager at Fort Washington Investment Advisors. "Inflation is drifting lower, which is keeping the Fed cuts on the table. But to get the near-term cuts, you need to see more weakness in the labor market."
Tuesday's inflation release marked a return toward normality after last year's six-week US government shutdown distorted the readings for October and November. The core consumer price index, which excludes the volatile food and energy categories, increased 0.2% from November, compared with economists' median forecast of 0.3%. On an annual basis, it advanced 2.6%, matching a four-year low.
"It should be encouraging to markets for sure," said Jan Nevruzi, a strategist at TD Securities. "I don't think it changes the math for January at all as the last labor market data sealed that skip."
The Fed has cut rates three times since September to counter signs of weakness in the labor market, decisions that have been contentious because inflation remains higher than the central bank's 2% target. Two Fed officials dissented from the December rate cut in favor of no action, while one favored an even larger reduction.
Economists and traders see the case for additional Fed interest-rate cuts resting on the health of the jobs market.
An unexpected drop in the US unemployment rate in December reported Friday spurred several Wall Street banks — including Morgan Stanley, Barclays and Citigroup — to push their forecasts for Fed rate cuts later into 2026. Strategists and economists at JPMorgan Chase & Co., meanwhile, said they no longer expect a cut at all this year and see a rate hike next year.
"Our take was that as inflation has taken a back seat to the employment figures, today's data was unlikely to shift the January Fed pause pricing. That appears to be the market's response," wrote Ian Lyngen, head of US rates strategy at BMO.
On Tuesday, two-year Treasury yields at around 3.55% were the highest in several weeks ahead of the inflation report. More sensitive than longer maturity yields to monetary policy shifts, two- and five-year yields immediately fell as much as about 3 basis points after the CPI data. The declines were pared to about a basis point by mid-morning in New York, while 10-year yields erased their decline and rose by about a basis point.
The 30-year bond auction at 1 p.m. New York time — a $22 billion second reopening of the November new issue — was poised to draw the highest yield for a comparable sale since July, around 4.83%. Prevailing 30-year yields have risen outright and relative to shorter-term yields since the end of October, underpinned by expectations for Fed easing that could be inflationary and the steep US borrowing need.
Bond traders also are mindful of the potential for a US Supreme Court ruling Wednesday on tariffs the White House has been enforcing this year, which have lessened the borrowing need marginally. An adverse ruling could draw a negative market reaction, even as the administration has alternative legal avenues for most of the levies.
Treasury yields have been confined to narrow ranges over the past month — the 10-year from 4.2% to 4.2% — despite a barrage of administration initiatives including mortgage-market intervention to influence the housing market.
Even the latest threats to Fed independence have failed to leave a lasting mark. The Justice Department's grand jury investigation of Fed Chair Jerome Powell revealed over the weekend has drawn to his defense several Republicans in Congress and foreign monetary authorities including the European Central Bank, Bank of England and the Bank of Canada.
--With assistance from Michael MacKenzie, Carter Johnson, Alice Gledhill and Kristine Aquino.
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