Traders began to abandon hopes that the Federal Reserve would cut interest rates in March, just as one of the bond market's most closely watched gauges of long-term inflation expectations rose.
Fed funds futures were trading at Friday levels suggesting a 52.6% chance of no quarter-point rate cut at the Fed's March meeting, according to the CME FedWatch tool. This is the highest probability of no action at that meeting in more than a month. In addition, traders pulled back slightly due to the chances of up to seven interest rate cuts by December.
Meanwhile, the two- and five-year expected inflation rate rose to 2.4% as of Thursday — up from 2.25% at the beginning of this year, according to the latest data from the Federal Reserve Bank of St. Louis. While the size of the price rise may seem minor, it is the upward trajectory that matters. The five-year and five-year forward rates are seen as providing a more timely reading than Friday's report from the University of Michigan, which showed inflation expectations for next year fell to the lowest level since December 2020.
The gauge, which tracks expectations for average inflation in the five-year period starting five years from now, is rising after a batch of strong US data this week. Data as of Thursday.
Federal Reserve Bank of St. Louis
“There are probably some elements in the University of Michigan data that look somewhat reactionary,” with consumers anticipating a further decline in inflation due to lower gas prices last year, said Thomas Simons, US economist at Jefferies Jeffers.
“Markets are looking at inflation very closely and think it could get very difficult,” Simons said by phone on Friday. All of this “certainly indicates that the five to seven cuts that markets have been envisioning are completely wrong. If the inflation trend is higher or continues to stay where it is, some of these cuts will have to be implemented.”
Investors and traders began 2024 hoping inflation would continue to ease toward the Fed's 2% target, which would then allow policymakers to deliver what are known as “maintenance” cuts to prevent interest rates from becoming too restrictive. Instead, Fed officials have been pushing back on market thinking, especially on the idea of a first rate cut in March.
Inflation, based on the annual headline CPI rate, rose to 3.4% in December, despite the fact that the Fed's main policy target was between 5.25% and 5.5%, the highest level in nearly 23 years.
Traders look to the 5-year and 5-year forward rates because they provide an indication of where inflation is likely to stabilize in the longer term, after near-term risks subside. The rate also rose in November in the absence of any major developments, underscoring the bond market's continued focus on the potential for further upside rate gains.
See also: Inflation 'far from dead': Why one major asset manager doubts US could hit 2%
Treasury yields ended mostly higher on Friday, sending the policy-sensitive two-year interest rate BX:TMUBMUSD02Y to a one-month high of 4.406%, after University of Michigan data showed consumer sentiment rose in January. US stocks DJIA SPX COMP also closed higher, buoyed by investor enthusiasm for AI names, with the S&P 500 hitting a record close at around 4,840.
On Thursday, an $18 billion auction of 10-year inflation-protected Treasury securities was met with strong investor demand, signaling the continued need for inflation protection.
