Treasuries Slump as Hot Inflation Lifts Fed Rate-Hike Bets

US Treasuries slumped after hotter-than-expected inflation prompted traders to add to wagers that Federal Reserve officials will raise interest rates later this month and next year.

The declines on Wednesday drove yields higher across maturities, with the two-year note’s — more sensitive than longer-term debt to Fed rate changes — climbing as much as 16 basis points to 4.95%. The five-year yield reached a level last seen in 2007, and the dollar surged to its highest level of the year.

Traders priced in a roughly coin-toss probability that the US central bank boosts rates at its October meeting after consumer prices advanced at the fastest pace in five months on rising fuel costs. Two 25-basis-point hikes were fully priced in by the end of January.

“We had that October hike in our forecast,” Robert Sockin, PGIM’s chief US economist, said on Bloomberg Television. “This opens the door more to it.”

The consumer price index rose 0.6% in September, according to Bureau of Labor Statistics data. It climbed 3.7% from a year earlier, exceeding economists’ 3.6% median forecast. A measure of underlying inflation — prices excluding food and energy — also exceeded forecasts as it rose 0.3% from August and 2.6% from a year earlier.

Treasuries have been mostly selling off for months on concern that elevated energy prices tied to the war in Iran will keep upward pressure on inflation, forcing major central banks to boost interest rates. Fiscal concerns exacerbated the moves, pushing long-dated bond yields to multi-decade highs.

After lofty yields attracted some buyers in recent sessions, Wednesday’s losses unleashed buyers’ remorse.

“My concern is that we just started getting some optimistic positioning in the last 10 trading days, and now the underlying thesis is being tested,” Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott. “That sets the stage for a quick whoosh of selling.”

The price action raises the stakes for the Fed’s next rate-setting meeting in late October. With inflation running above the central bank’s target for years, expectations have risen for further tightening. After Wednesday’s data, traders began to price in almost four rate increases over the coming year. That compares with pricing for about three hikes seen before the report.

What Bloomberg Strategists Say...“With headline inflation up 3.7% year-over-year, the risk of longer-term expectations drifting higher bears watching. Bonds’ reaction demonstrates that concern. Though the front of the curve will bear the brunt of the post-CPI Fed repricing, those longer-term breakevens will be key for signs the central bank will be forced to react more aggressively to inflation worries.”— Edward Harrison, Markets Live strategist. Click here for full analysis.

In the options market linked to the Secured Overnight Financing Rate, which tracks the Federal Reserve policy outlook, main flows in the aftermath of the inflation data was selling of hawkish protection, consistent with unwinding positions as traders looked to take advantage of the hawkish shift in policy pricing.

Chairman Kevin Warsh is scheduled to speak Thursday in a discussion at the International Monetary Fund’s annual meeting.

“An October rate hike is not our base case, but hot inflation data has taken the probability to around 50%,” said Monty Gandhi, rates strategist at SMBC.