The US Treasury market saw yields retreat from their session highs on Friday, December 20, 2024, following the release of key inflation data that fell short of market expectations. This development prompted traders to adjust their outlook for Federal Reserve interest-rate reductions in the coming year.
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Easing Inflation Fuels Rate Cut Speculation
The yield on the two-year Treasury note, a key indicator of market sentiment toward future Fed policy, dipped to 4.31% in late afternoon trading on Friday, after initially sliding to 4.25%. The benchmark 10-year Treasury yield also experienced a decline, settling at 4.51% after shedding 4 basis points. These movements reversed a sharp steepening trend observed earlier in the week, which had driven a segment of the yield curve to its steepest incline since 2022. Treasuries maintained their initial gains even after a University of Michigan survey revealed a fifth consecutive month of improvement in US consumer sentiment in December.
The pivotal inflation data released earlier on Friday indicated that the core personal consumption expenditures (PCE) price index, the Federal Reserve’s preferred gauge of underlying inflation, rose by a mere 0.1% from October and 2.8% year-over-year in November. Both figures were slightly below consensus forecasts.
Illustrative example of a yield curve steepening.
Market Anticipates More Aggressive Fed Action
Current market pricing suggests that swaps traders anticipate approximately 39 basis points of cumulative Fed rate cuts in the next year. This implies fewer than two full quarter-point reductions. However, many Wall Street analysts predict a more substantial easing of monetary policy by the central bank.
Subadra Rajappa, head of US rates strategy at Societe Generale, expressed this sentiment during an interview on Bloomberg Television, stating, “We are anticipating more cuts from the Fed next year.” She further elaborated that Societe Generale’s economists foresee four quarter-point Fed rate cuts in the coming year. Rajappa attributed this outlook to the anticipated moderation in economic growth, employment, and inflation.
Yield Curve Steepening Reflects Shifting Expectations
Earlier in the week, selling pressure on longer-dated debt instruments propelled the 10-year Treasury yield above the two-year rate by the widest margin witnessed since 2022. This steepening of the yield curve followed the Federal Reserve’s signaling on Wednesday of a potential slowdown in the pace of rate cuts next year, citing persistent inflationary pressures. The median projection from Fed officials’ quarterly forecasts indicated two quarter-point rate reductions in 2025, compared to the four moves projected in September.
The Federal Reserve Board Building in Washington D.C.
Navigating Uncertainty in the Bond Market
Julian Potenza, portfolio manager at Fidelity Investments, commented on the Fed’s communication strategy, stating, “The Fed is trying to communicate a shift to the next phase in the easing cycle.” He acknowledged the wide range of potential policy outcomes for the next year but emphasized that Fidelity Investments considers a continuation of a modest easing cycle as the most likely scenario. Concerns surrounding President-elect Donald Trump’s potential fiscal policies, which could lead to increased spending and wider deficits, have also contributed to investor hesitancy in committing to longer-term US securities.
While some unwinding of positions after a volatile week might trigger a partial reversal of the steepening trend, investors like Michael Hunstad, deputy chief investment officer at Northern Trust Asset Management, which manages $1.3 trillion in assets, maintain their expectation for a continued steepening of the yield curve.
Conclusion: Inflation Data and Future Fed Policy
The latest inflation data and subsequent market reaction underscore the ongoing debate regarding the future trajectory of Federal Reserve monetary policy. While market participants have adjusted their expectations for rate cuts in the coming year, considerable uncertainty remains. The interplay between cooling inflation, economic growth prospects, and the Federal Reserve’s policy decisions will continue to shape the dynamics of the US Treasury market in the months ahead.
