August’s U.S. consumer price index, showing a slowdown in the recent surge in inflation, is easing the bond market’s fears that the Federal Reserve might be forced to hike interest rates by more than expected down the road.

The report, released Tuesday, wasn’t decisive enough to settle the debate over whether inflation will prove to be transitory or not, investors and analysts say. Nevertheless, the view — at least, for now — is that the central bank will be able to keep low interest rates in place for quite some time. Meanwhile, the decision on when to pull back on monthly bond purchases, a prerequisite step before hiking rates, will ultimately be determined by labor-market improvement.

Treasuries rallied on Tuesday’s data, pulling yields lower across the board, as traders took out some inflation premium and reduced their expectations for how soon the Fed could start lifting rates, as well as by how much. Two widely followed spreads — the gaps between 2- and 10-year Treasury yields and 5- to 30-year rates — had brief spikes, which have since faded.

After the inflation report, eurodollar futures traders pushed the timing of the first rate hike out by one month to around May 2023, and also lowered the terminal fed funds rate, or the neutral interest rate that is consistent with full employment and stable prices, by 8 basis points to 1.40%, according to Gennadiy Goldberg, a senior U.S. rates strategist at TD Securities. Meanwhile, the decline in yields was led by 10-
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to 30-year maturities
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on the view that “inflation is not necessarily going to overshoot in the long run.” The rate on 10-year Treasury Inflation-Protected Securities also moved lower, while its 5-year counterpart was off its highest level of the day.

“For months now, the market has been extremely concerned that inflation would run away,” Goldberg said via phone. “The market is now seeing that some of these Covid-impacted segments — like airfares, used cars, and hotels– can actually go into reverse.”

Until recently, much of the attention leading up to next week’s Federal Open Market Committee meeting in Washington had been on the prospect for paring back on $120 billion in monthly bond purchases. But investors also have their eye on policy makers’ interest-rate projections for 2024, which is being added to forecasts for the first time. So far, officials have penciled in two rate hikes for 2023, and a fed funds rate that hits 2.5% in the longer term.

“The trend in inflation is hard to tease out from Tuesday’s data, but a softening in CPI doesn’t indicate that inflation worries are over,” said Thomas Graff, a portfolio manager at Brown Advisory, which oversaw about $128 billion in client assets as of June. “The narrative is still out there that investors or the Fed are going to be spooked by near-term inflation prints into hiking too soon. If inflation backs off a little, that would allow the yield curve to price in stronger growth.” 

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