Bond Report: Treasury yields slide after July U.S. inflation report delivers downside surprises

Treasury yields fell sharply Wednesday morning, led by 2-, 3- and 5-year maturities, after a better-than-expected U.S. inflation report encouraged investors to pare bets on sharp interest rate increases by the Federal Reserve.

What’s happening

The yield on the 2-year Treasury

fell to 3.116% from 3.284% on Tuesday afternoon.

The yield on the 10-year Treasury

retreated to 2.719% from 2.797% late Tuesday.

The yield on the 30-year Treasury

fell to 2.974% from 3.004% on Tuesday.

The 2-year to 10-year spread shrank to minus 40 basis points from almost minus 50 basis points, but the yield curve remains close to its most inverted in two decades in a potential signal of an economic downturn.

What’s driving markets

The U.S. consumer price index (CPI) report released on Wednesday showed year-on-year inflation in July of 8.5%, down from 9.1% in June and below the 8.7% forecast by economists. The pullback in inflation was largely caused by falling energy prices, but there was better news on core prices, too.

See: U.S. consumer price inflation cools in July, core prices sticky

The year-on-year core price measure — which strips out volatile food and energy costs and is considered a better indicator of how ‘sticky’ inflation could be — came in at 5.9%, the same as June and below the 6.1% feared by analysts. It was the first time since April that the CPI report “brought  unexpected good news on inflation,” said FHN Financial’s chief economist Chris Low.

Investors piled into bonds in response, while stocks opened higher. Dow industrials surged more than 500 points in the first hour of trading.

“The deceleration in the Consumer Price Index for July is likely a big relief for the Federal Reserve, especially since the Fed insisted that inflation was transitory, which was incorrect,” said Nancy Davis, founder of Quadratic Capital Management.

“If we continue to see declining inflation prints, the Federal Reserve may start to slow the pace of monetary tightening,” Davis added.

Paul Ashworth, chief U.S. economist at Capital Economics was more cautious: “Overall, with headline inflation still at 8.5% and core inflation at 5.9%, this is not yet the meaningful decline in inflation the Fed is looking for. But it’s a start and we expect to see broader signs of easing price pressures over the next few months.”

Still, markets moved swiftly to reprice the prospects for Fed monetary tightening. Before the report was released traders were giving a 67.5% chance of a 75 basis point rate hike at the Fed’s September meeting. That was down to 40.5% and the chances of a 50 basis point hike were 59.5%, according to the CME FedWatch Tool.

The central bank is mostly expected to take its borrowing costs to a range of between 3.5% and 3.75% by next March, according to fed funds futures traders.

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