(Bloomberg) -- Treasuries gained ahead of the release of US inflation data, paring sharp losses sparked by the temporary US-China trade truce that's dimmed the odds of a global recession.
With market-implied expectations for Federal Reserve interest-rate cuts receding and a multi-trillion-dollar tax package seen likely to worsen the US government budget deficit, focus is now on Tuesday's inflation data for any signs of a pickup in price pressures. The report will be the first to show tariff-related costs.
The yield on policy-sensitive two-year bonds fell nearly three basis points to 3.98% on Tuesday, outperforming European peers. The rate surged 12 basis points on Monday after the world's biggest economies agreed to temporarily cut tariffs, dimming the odds of a recession and fueling a rally in risk assets.
"The 'trade-relief rally' has started to stall overnight," said Evelyne Gomez-Liechti, a strategist at Mizuho International. The moves reflect "profit-taking and consolidation ahead of today's CPI report. We think there's room for more."
Economists forecast the annual pace of consumer price growth held the same as the month prior, according to estimates compiled by Bloomberg. Core inflation is expected to remain at a 2.8% level.
Traders have lowered their expectations for Federal Reserve interest-rate cuts this year amid easing trade tensions, and swaps now favor a quarter-point cut by September and another to follow by year-end. At the end of last month, markets were betting on a first move by July, and a total of four cuts this year.
Barclays now expects the Federal Reserve to deliver just one interest-rate cut this year compared to two previously.
"If you have to put a gun to my head and say what's the most likely single view it probably would be that the Fed maintains rates on hold this year because inflation stays pretty elevated," said Mark Dowding, chief investment officer of BlueBay Fixed Income.
Fed Governor Adriana Kugler said even with the 90-day levy reduction on Chinese goods, President Donald Trump's tariff policies risk sparking a rise in inflation and unemployment.
Bloomberg Economics estimates the new tariff levels will translate into a 1.5% hit to US GDP and 0.9% boost to core PCE over a period of two to three years, about half the shock predicted before the US-China talks.
Since the end of April, US government bonds have slumped, pushing yields across all maturities higher. Benchmark 10-year yields trade at 4.45%, well above the lows of this month of 4.12%. Policy sensitive two-year yields have risen nearly 40 basis points.
Dowding said he is looking to buy 10-year Treasuries if yields move back to 4.8% — around the peak level of 2025 reached in mid-January — and sell them if rates fall below 4.2%.
Tax Bill
Despite the administration touting they can extend Trump's 2017 tax cuts without worsening the US deficit, market participants are less clear that will pan out. The plan announced Monday will take a big step toward advancing through the House as soon as this week, with the House Ways and Means Committee scheduled to begin debate on it Tuesday.
Economists at Deutsche Bank in a note earlier this month said the final package will likely keep the US deficit-to-GDP level stuck near 6.5% for the next few years.
"If you look at what's coming down the road out of Washington, the administration is talking about Independence Day for the tax package," said Gregory Faranello, head of US rates trading and strategy for AmeriVet Securities. "So the Fed is going to wait that out," as well as move slowly to monitor economic data.
Faranello also sees rising Treasury yields as providing good opportunities to purchase more debt as he expects the labor market to crack and the Fed cutting rates sometime in the second half of the year.
--With assistance from Aline Oyamada.
(Updates with latest Treasury moves, Barclays forecast.)
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