Traders are abandoning their expectations of a Federal Reserve interest rate cut in March, coinciding with a notable increase in one of the bond market's closely monitored indicators of long-term inflation expectations.
As of Friday, Fed-funds futures indicated a 52.6% chance of no quarter-point rate cut at the Fed's March meeting, according to the CME FedWatch Tool. This represents the highest probability of inaction at that meeting in over a month. Concurrently, traders scaled back their expectations for up to seven rate cuts by December.
Meanwhile, the 5-year, 5-year forward inflation-expectation rate rose to 2.4% as of Thursday, up from 2.25% at the beginning of the year, as reported by the Federal Reserve Bank of St. Louis. Although the increase in the rate might seem modest, the significant factor lies in its upward trajectory. The 5-year, 5-year forward rate is considered a more timely indicator compared to the recent University of Michigan report, which revealed that inflation expectations for the year ahead dropped to the lowest level since December 2020.
Thomas Simons, U.S. economist at Jefferies, suggested that the University of Michigan data may be somewhat backward-looking, with consumers anticipating further inflation declines due to last year's drop in gas prices. Speaking on Friday, Simons noted that markets are closely monitoring inflation, contemplating the possibility of it becoming persistent. This observation challenges the prevailing market sentiment, indicating that the envisioned five to seven rate cuts may be incorrect. If inflation continues to rise or remains persistent, some of those anticipated cuts might need to be reconsidered.
At the outset of 2024, investors and traders were optimistic that inflation would continue to subside toward the Fed's 2% target, paving the way for what is known as "maintenance" cuts to prevent interest rates from becoming overly restrictive. Contrary to these expectations, Fed officials have countered the market's assumptions, particularly regarding the prospect of a rate cut in March.
In December, the annual headline rate of the consumer-price index reported an inflation increase to 3.4%, surpassing the Fed's primary policy target range of 2% to 2.5%. This development, the highest in almost 23 years, has fueled the ongoing debate on inflation expectations.
Traders closely monitor the 5-year, 5-year forward rate as it offers insights into where inflation is likely to settle over the long term after short-term risks have subsided. The rate had already experienced a slight uptick in November, emphasizing the bond market's persistent focus on the potential for further price gains.
Treasury yields predominantly increased on Friday, propelling the 2-year rate to a one-month high of 4.406%, influenced by robust consumer sentiment data from the University of Michigan. U.S. stocks also concluded higher, driven by investor enthusiasm for artificial intelligence-related stocks, with the S&P 500 achieving a record close at 4,839.81.
Furthermore, Thursday's successful $18 billion auction of 10-year Treasury inflation-protected securities reflected strong demand from investors, indicating a sustained need for protection against inflation. This development underscores the ongoing uncertainty in the market regarding the trajectory of inflation and its implications for monetary policy.
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