Tonight, the U.S. August CPI data faces a major test, and the bond market bets on a significant change in the Federal Reserve's interest rate cuts

According to the Zhitong Finance APP, tonight, the U.S. August CPI data will be released, and bond traders are preparing for it, which may weaken their bets on a series of significant interest rate cuts by the Federal Reserve starting this month and continuing until 2026. Weak employment data and moderate producer price data have led traders to believe that a 25 basis point rate cut at the Fed's meeting on September 16-17 is a done deal, with possibly two more such cuts by the end of the year. However, beyond that, the market's view on the balance of economic risks has changed, with current market positioning leaning towards the belief that officials will ultimately lower rates below what is considered a neutral level, to the extent that policy will stimulate economic growth to avoid recession.

This marks a significant shift, as for much of the past year, traders have hesitated to bet on such large-scale easing policies due to persistently high inflation. This situation has heightened attention on the U.S. Consumer Price Index report set to be released on Thursday Eastern Time, which is expected to show core annual readings well above the Fed's target. After a month-long rebound that pushed the yield on U.S. two-year Treasury bonds down to its lowest level since April, the risk is that investors may be overly optimistic.

"The front end has priced in a weaker economy without paying attention to inflation," said Ed Al-Hussaini, portfolio manager at Columbia Threadneedle Total Return Bond Fund. "If the focus shifts back to inflation, if the data is high, the front end will be a bit vulnerable."

A report on Wednesday showed that the U.S. Producer Price Index unexpectedly fell in August. Following the data release, yields dropped, with the two-year U.S. Treasury yield, which is closely tied to the Fed's policy outlook, briefly falling 5 basis points to 3.51% on Wednesday. When Asian markets opened on Thursday, the yield changed little at 3.55%.

Bloomberg macro strategist Cameron Christ stated, "The Producer Price Index poses almost no obstacle to the Fed's easing policy; however, the components included in the Personal Consumption Expenditures Price Index (PCE) do not have the same dovish implications as the unexpected declines in the overall and core indices."

Traders tend to believe there will be three 25 basis point cuts by the end of the year, with possibly a few more of the same magnitude around 2026. This would push the federal funds rate down to just below 3%, while officials predicted a long-term rate of 3% in June, which is viewed as the neutral rate—neither stimulating nor suppressing growth.

Obstacles to CPI

Even though economists predict that the core consumer price growth rate will remain at an annual rate of 3.1% in August, this view of the Fed's rate cut path has emerged in the market.

"The market is pricing in such large rate cuts in the context of persistently high inflation—such a very, very rapid rate cut trajectory is hard to believe," said Megan Swiber, head of U.S. interest rate strategy at Bank of America. "We tend to see 3% as the upper limit for the market trading at the bottom of the cycle."

She noted that if the rise in CPI is more driven by inflation related to tariffs on goods, this dynamic may persist, as some Fed members have indicated that this inflation may be temporaryThe median forecast released by officials in June shows that the federal funds rate will be 3.63% and 3.38% at the end of 2026 and 2027, respectively. The current rate is set in the range of 4.25% to 4.5%. Next week, officials will also release new rate forecasts, known as the "dot plot."

As the Federal Reserve is expected to resume interest rate cuts, and other developed countries have also lowered borrowing costs this year, global bonds have been rising. However, the performance of long-term bonds has lagged, as investors remain cautious about government spending. The yield on the 30-year U.S. Treasury bond rose to about 5% last week, the highest level since July, before signs of a softening labor market triggered a retreat in yields.

Trump's Pressure

Of course, part of the market positioning reflects U.S. President Donald Trump's repeated criticism of Federal Reserve Chairman Jerome Powell for being too slow to cut rates, as well as broader attempts to influence the Fed.

Benson Durham, global asset allocation chief at Piper Sandler and former Fed economist, stated, "There are also some political economic factors regarding the outlook for the federal funds rate over the next year, as it is now clear that a condition of serving at the Fed is that you must significantly cut rates."

Currently, Powell and other officials have indicated that their key rate is above neutral levels, meaning it is restricting the economy to cool inflation.

Matthew Hornbach, global macro strategy chief at Morgan Stanley, noted in a report with colleagues that investor concerns about economic downside risks will increase, thereby driving demand for the Fed's easing policies.

"We believe investors will push the market to price in a trough for the Fed's policy rate well below the low point of September 2024," Hornbach and his colleagues wrote. They referred to last year's situation where traders believed the federal funds rate would drop to around 2.7% during the cycle