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Market Extra: Stronger-than-expected U.S. inflation data has bond traders weighing the risk of a Fed policy error

Stronger-than-expected U.S. inflation data for September has the bond market now considering the risk that the Federal Reserve may end up being forced to tighten interest rates into a stagnating economy with persistently higher price rises.

Consumer price index readings have come in at 5% or higher on a year-over-year basis for five straight months, undermining the “transitory” theme put forward by central bankers. Bond traders reacted to Wednesday’s report by sending Treasury yields lower on maturities from seven years and out, causing the widely followed spread between two- and 10-year Treasury yields to narrow.

Wednesday’s market moves are important because they signal what some economists say is a shift that’s under way in the minds of traders and investors. Until recently, many had chosen to give the Fed the benefit of the doubt, siding with the central bank’s transitory narrative that inflation will be transitory.

However, with the exception of rates between the 3-month bill and the 3-year note which moved higher, the fall in Treasury yields Wednesday after the CPI data included a surprising temporary decline in the five-year yield
TMUBMUSD05Y,
1.089%

to as low as 1.047%, and possibly reflected the impact of the Fed’s forthcoming interest rate-hike cycle, analysts said.

Earlier in the day, the Dow Jones Industrial Average DJIA dropped by around 100 points before recovering. The Dow industrials then headed higher by less than 0.1%, while the S&P 500 SPX erased its earlier losses and was up by 0.3%. The tech-heavy Nasdaq Composite Index
COMP,
+0.64%

was up by 0.7%

“The inflation numbers weren’t great and people think the Fed is not going to let inflation get out of hand,” said David Petrosinelli, a senior trader at InspereX in New York, in a phone interview. “Right now, there are a basket of things going on. One of them is that the Fed’s hand may be forced to unwind QE purchases faster than Chairman Jerome Powell would like. The policy error would be that the Fed has waited too long to hike, and may be forced to hike by too much.”

The data released on Wednesday showed consumer-price gains rising at a 5.4% year-over-year pace last month, above the 5.3% consensus estimate, and staying at a 30-year high. That’s more than double the Fed’s 2% target, and confirmed fears that many forecasters have been underestimating the underlying strength behind the recent surge of inflation. Echoing a similar sentiment on Tuesday was Atlanta Fed President Raphael Bostic, who said the rise in inflation should no longer be considered “transitory,” in an apparent break with other Fed leaders.

Minutes of the Fed’s Sept. 21-22 meeting, released Wednesday, showed that policy makers discussed a plan to reduce asset purchases by $15 billion per month, but several of them preferred a more rapid reduction. Furthermore, the tapering process might begin in either mid-November or mid-December, the minutes showed.

The Fed has held the target for the fed-funds rate between 0 and 0.25% since March 2020, to support a pandemic-stricken U.S. economy. It isn’t expected to start raising interest rates again until sometime next year.

Inflation fears may already have begun denting consumer and business confidence, though the September data reflected “moderate growth in prices” relative to mid-year, said Rick Rieder, chief investment officer of global fixed income at BlackRock Inc., which manages $2.7 trillion in fixed-income assets.

Policy makers have “generally navigated the economic side of the COVID crisis decently well,” though they seem to have fallen “behind the curve in the last six months, or so,” Rieder said in a Wednesday note. “It would be greatly disappointing to see the central bank not only not `stick the landing’ but in fact stumble in a way that injures the recovery.”

After Wednesday’s CPI report, a multitude of buyers stepped into the Treasury market from a variety of accounts, including central banks, according to trader Tom di Galoma of Seaport Global Holdings in Greenwich, Connecticut. Decent demand also came from investors in Japan and China overnight, while U.S. hedge funds were “being forced to cover” after selling off Tuesday night.

“The debate currently going on in the market is, `Is this economy going to be 2% to 3% in GDP going forward?’ ” di Galoma said via phone Wednesday. “There are a lot of constraints in the economy, as far as supply-and-demand issues, that seem to be causing the inflation that we’re seeing. It’s very much a possibility that Fed officials have waited too long to start tightening and start cutting back on all the QE they’ve been doing.”

Related: How stock-market investors can make sense of supply-chain chaos

“We’re at a point where things aren’t clicking as they should be, and Powell’s being forced into a position of scale back QE at a time when it should have been done six months ago,” he said.

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