Last week’s soft inflation data and recent weakening labor make it increasingly likely that the Fed will cut rates starting in late summer. Interest rates markets are pricing in a 94% probability of the first rate cut commencing in September with at least one more in November or December. From there, markets expect a rate cut once per quarter until the federal funds rate reaches a range of 3.50% to 3.75% in March 2026.
Last week, the June CPI measures came in well below expectations, with headline CPI contracting by 0.06% on the month, and core CPI growing at only 0.06%, its lowest print in 41 months. This was well below consensus expectations of 0.10% growth in CPI and 0.20% growth in core CPI. Shelter inflation, one of the largest contributors to core CPI, continued its slowing trend.
Overall, with CPI and core CPI now growing by 2.97% and 3.27%, respectively, on a year-over-year basis, the runway is clear for rate cuts to commence in September. In response to the soft inflation figures, the yield curve moved in a “bull steepening” fashion. The 2Y Treasury yield fell by 17 basis points and the 10Y fell by 10 basis points in the two days following the CPI print.
Fed communication and inflation data have largely ruled out any rate hikes in the US, so the upside is effectively capped for yields in the near term. Any further weakness in the labor market would certainly result in deeper rate cuts than is priced in by the market and yields would shift lower across the yield curve.
As we wrote last week, rate cutting phases typically result in falling yields and steeper curves, and we continue to believe the outcome for interest rates is skewed to the downside. Historically, during periods of rate cutting, fixed income total returns have been solid, with the average total return of the Aggregate Bond Index at +8.65%.
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