Cooling Inflation Weakens July Rate Hike Expectations, US Treasuries Edge Up This Week

According to Zhitong Finance APP, the U.S. Treasury market saw a slight increase this week as cooler inflation data boosted market sentiment, offsetting the pressure from a sharp rebound in international oil prices. As a result, traders significantly reduced their bets on a Federal Reserve rate hike in July. However, surging oil prices and continued hawkish signals from Fed officials mean that the market still expects another rate hike before the end of the year.

Both the U.S. Consumer Price Index (CPI) and Producer Price Index (PPI) released this week indicated that inflationary pressures have eased, driving overall U.S. Treasury yields lower. Among them, short-term Treasuries, which are most sensitive to monetary policy, performed best, with the largest declines in yields.

However, the sharp rise in international oil prices capped gains in the bond market, as investors still believe rising energy prices could reignite inflation, prompting the Federal Reserve to continue tightening monetary policy later this year.

Molly Brooks, U.S. Rates Strategist at TD Securities, noted that after this week’s inflation data was released, the market clearly lowered its expectations for further Fed rate hikes, especially with the probability of a near-term hike having dropped significantly.

Interest rate swaps markets show traders now see about a 15% chance for the Fed to raise rates by 25 basis points at the July 28-29 FOMC meeting, down from about 50% previously. With almost no major economic data scheduled before the meeting and the Fed entering its "blackout period," there is limited room for further adjustment in the market's July policy expectations.

As a result, the U.S. 2-year Treasury yield fell by 3 basis points this week, closing at 4.18%.

However, there remains significant divergence in the market regarding the Fed's medium- to long-term policy path. Recently, support within the Fed for further rate hikes has grown, with even some previously dovish officials turning more hawkish.

Cleveland Fed President Loretta Mester said on Friday that with consumer spending remaining resilient and unemployment still low, persistently high inflation remains her top concern.

Dallas Fed President Lorie Logan also stated on Thursday that the U.S. might need to "moderately raise interest rates" because there is not yet enough evidence that inflation can sustainably fall back to the Fed’s 2% target.

In fact, both Mester and Logan have long been among the more hawkish voices within the Fed, and both opposed signaling a potential rate cut in the April policy statement earlier this year.

Meanwhile, escalating tensions in the Middle East have once again increased the risk premium in the energy market. This week, the U.S. launched a new round of military strikes against Iran, causing significant volatility in international oil prices. On Friday, West Texas Intermediate crude futures settled at $82.49 per barrel—up nearly 16% for the week and reaching their highest closing level since June 12.

Despite the recent improvement in U.S. inflation data dampening expectations for a short-term rate hike, the rebound in energy prices combined with persistent hawkish signals from Fed officials means the market has not entirely given up on another rate hike this year. The Fed’s future policy path will remain dependent on inflation trends and energy price changes.