Traders bet on quarter-point Fed cut this month after rise in core inflation

Traders are uniting behind bets the Federal Reserve will cut interest rates by only a quarter-point next week after an unexpected pickup in underlying U.S. inflation in August.

The so-called core consumer price index, which excludes food and energy costs, increased 0.3% from July and 3.2% from a year ago, Bureau of Labor Statistics figures showed Wednesday. Economists see the core gauge as a better indicator of underlying inflation than the overall CPI.

The read for August mostly eliminated the case for a bigger half-point rate reduction, fortifying wagers on a more gradual pace of cuts. Even economists at Citigroup Inc. scaled back their bold prediction for a bigger cut this month.

“We were never in the 50 basis point camp, and it seems like the modest upside surprise in CPI would likely be enough to give any policymakers considering a bigger move pause,” said Zachary Griffiths, head of U.S. investment grade and macro strategy at CreditSights.

The policy-sensitive two-year yield rose as much as 9.5 basis points, to 3.69%, with the 10-year note backing up 4 basis points to 3.68%, still near their lowest levels since the first half of 2023.

The consumer price index result represents a key piece of economic data ahead of next week’s Fed meeting. Treasuries have been rallying since the end of April as signs of cooling inflation and slower job creation have firmed expectations for the first central bank rate cuts since 2020.

“Inflation has now cooled to room temperature, there is really not a significant inflation problem,” David Kelly, chief global strategist at JPMorgan Asset Management, told Bloomberg Television after the CPI report was released Wednesday.

The report “does not call for drastic Fed action and I would be happy to see 25 basis points next week,” Kelly said.

The central bank has held its current rate band of 5.25% to 5.5% since July 2023, and as inflation pressure had subsequently moderated that policy setting has become more restrictive. That has spurred Fed officials in recent weeks to set the stage for an easing cycle to start this month.

Interest-rate swaps showed that traders have fully priced in a 25-basis-point Fed cut at the Sept. 18 policy announcement and see only a small chance for a half-point reduction. Fed swaps are pricing in about 145 basis points of rate cuts by the Jan. 29 rate decision, equivalent to roughly two half-point moves over the next four gatherings barring no intra-meeting event.

On Wednesday, following the CPI data, Citi economists ditched their forecast for a half-point rate cut at next week’s Fed meeting, while maintaining their call for a total of 125 basis points of easing this year. JPMorgan Chase & Co. appears to be the only holdout sticking with its bet that the Fed would slash rates by a half-percentage point this month.

While Fed officials have identified a weakening labor market would spur a faster pace of easing in the coming months, recent employment data continues to show a resilient jobs sector, testing the patience of rate traders betting on the prospect of outsized cuts later this year or early 2025.

“The Fed is going to go 25 basis points next week,” Andrew Brenner, head of international fixed income at NatAlliance Securities, said in a telephone interview.

In terms of market vulnerability, the two-year yield is likely to shift higher should the Fed deliver a measured pace of rate cuts that falls short of the 245 basis points of easing priced by futures contracts for September 2025.

“A point of pain is the front end as the market has priced in so many cuts,” said George Catrambone, head of fixed income, DWS Americas. “The Fed views this as coming off from being restrictive, they are not cutting for weakness in the economy. The Fed will have to be patient and so do investors as the economy is not falling apart.”

The rise in yields may help the market absorb the sale of $39 billion 10-year notes scheduled later in the session at a 1 p.m. New York time auction in New York.

“The market was betting on a better than expected CPI, so rates are going higher, which is good for people who need to buy 10-year notes at today’s auction,” Brenner said. “The Treasury market is way too rich given where the Fed is and the Fed’s methodical view for changing policy.”