U.S. Treasury traders reduce bets on easing; will this week's CPI shatter hopes for a September rate cut?

According to Zhitong Finance APP, for most of this year, bond investors have been almost certain that the Federal Reserve would cut interest rates again before September. Recently, this confidence has begun to waver. These emerging doubts have led to increased focus on this week's CPI inflation data, which will help determine the Fed's next course of action. This will also decide whether U.S. Treasuries can continue their strong performance from the first half of the year (even after experiencing several sharp fluctuations, the performance of U.S. Treasuries in the first half of the year remains the best in five years).

Zachary Griffiths, head of investment-grade and macroeconomic strategy at CreditSights, stated: "These consumer price index data will set the tone for the Fed's policy direction and risk sentiment for the second half of the year."

A series of strong employment data released in early July led traders to believe that the Fed would not cut rates at this month's meeting. They now also believe that the likelihood of officials cutting rates at the September meeting is about 70%, whereas just at the end of June, the market considered a rate cut in September to be almost a certainty.

This backdrop makes the release of the U.S. CPI for June, scheduled for Tuesday, even more significant. According to Barclays strategists, June has historically been the month with the largest absolute "surprises" in terms of values over the past few years.

Given that the tariff policies introduced by Trump have led to increasing price pressures, this may raise further questions about the September rate cut plans and could prompt investors to bet on rising yields. Conversely, if the report shows moderate performance, it may rekindle expectations for recent monetary easing.

Tracy Chen, a portfolio manager at Brandywine Global Investment Management, stated: "In the upcoming inflation report, we should be able to see the impact of the trade war. I believe the Fed will not cut rates in September. The strong labor market and the bubble-filled financial asset market do not provide a valid reason for a rate cut."

Her view is that, given the susceptibility of longer-term bonds to rising inflation, increased government spending, and changes in foreign demand, the yield curve is likely to steepen.

Divergence in Tariff Impact

Before the Fed makes its decision in September, there will be two more CPI data releases. Fed Chairman Powell has stated that officials need more time to assess the impact of tariffs on the economy before deciding whether to cut rates, indicating that they have remained patient in the face of Trump's ongoing pressure to lower borrowing costs.

These taxation measures have sparked new divisions among policymakers, and it has become even more difficult to clarify their impact after the U.S. President postponed the deadline for imposing punitive tariffs on trade partners to August 1 The result is that traders lack confidence in the future direction of the world's largest bond market, leading them to withdraw a large number of bullish bets over the past week. The impact of this uncertainty has left the market in a range-bound state, with the yield on the 2-year U.S. Treasury (which is most sensitive to Fed policy expectations) fluctuating between 3.7% and 4%, a situation that has persisted since early May. Meanwhile, the indicator measuring expected volatility of U.S. Treasuries has significantly retreated from the April highs reached due to tariffs, falling to its lowest level in nearly three years.

Economists predict that the June CPI report will show that the core inflation rate year-on-year growth will reach 2.9%, the highest level since February.

Bloomberg foreign exchange/rates analyst Alyce Andres stated, "Before the release of this week's inflation and consumer data, U.S. Treasury yields are at the midpoint of the expected range for 2025. Expectations for this data may keep bond yields within a familiar range, with current situations of buying on dips and selling on rebounds."

Investors who are concerned that U.S. Treasury prices will continue to fall due to strong inflation data may find some comfort in last week's auction results for the 10-year and 30-year U.S. Treasuries. These auction results showed strong demand, indicating that buyers may step into the market, thereby suppressing any selling activity.

Since December of last year, policymakers have maintained borrowing costs at current levels. Powell stated that the current interest rate level is "moderately restrictive," while the median forecast in the Fed's "dot plot" released last month indicated that there would be two rate cuts by the end of the year.

However, seven officials believe that rates will not decline in 2025, while ten officials believe there will be two or more rate cuts. Fed governors Waller and Bowman have expressed a desire to resume rate cuts this month.

Griffiths stated, "We remain concerned that tariff pressures on consumer prices may further intensify, forcing the Fed to adjust its policy direction in the short term, leading to an increase in U.S. Treasury yields across the entire yield curve, creating a mild bear market flattening effect."

John Lloyd, global head of multi-sector credit at Janus Henderson, stated that even if the next rate cut waits until after September, it may not disrupt the progression of easing policies. He believes this view may also help suppress the decline in bond prices. He added, "Two rate cuts by December have been priced in. Could one of them be canceled? Yes, but it is likely to be pushed to the first quarter of next year."