Global Rates & FX Views: CPI, Fed, & buyback implications

CPI Data Analysis and Core Inflation Outlook

• Core CPI came in at 0.3% month-over-month (0.29% unrounded), beating expectations of 0.22%.
  • The surprise was driven primarily by idiosyncratic factors rather than broad core services trends.
  • Wireless services increased by approximately 5.9%, contributing roughly 10 basis points to the core print, driven by AT&T pricing changes and the retirement of unlimited plans.
  • Airfares and lodging away from home added 8 basis points, with airfare volatility linked to jet fuel price increases stemming from geopolitical tensions in the Middle East.
  • Analysts view these specific drivers as volatile and one-off, reducing the report's signal value for future inflation trends.
• Core PCE inflation tracking has shifted firmer to 30 basis points month-over-month, up from 26 basis points following the PPI report.
  • Year-over-year core PCE is now projected at 3.1%–3.2% after accounting for upcoming methodology changes to computer software, legal services, and portfolio management.
  • Methodology adjustments for portfolio management and investment advice are expected to be slightly weaker than prior estimates, yet the overall PCE trajectory remains elevated.
• The consensus view among strategists is that underlying inflation remains "stuck" around 2.5% core PCE, even after accounting for rolling-off energy shocks and tariff reversals.
  • There is currently no policy impulse visible to reduce inflation from 2.5% to the 2% target.
  • The labor market outlook is now considered balanced, removing the fear of overheating and allowing the Fed to focus on bringing inflation down to 2%.

Federal Reserve Policy and September Outlook

• Markets are pricing an over 85% probability of a rate hike in September, with 75 basis points of total hikes this year viewed as the most credible path forward.
  • Bank of America maintains its call for three 25 basis point hikes in the second half of the year (September, November, and potentially December).
  • The market currently assigns less than a 40% probability to an October hike, though strategists warn that skipping October could undermine Fed credibility.
  • Strategists argue that the Fed should prioritize "pace" over "size" in communication to avoid the ECB scenario where markets overprice future tightening.
• The Federal Open Market Committee (FOMC) statement is expected to include language explicitly linking inflation persistence to the necessity of further rate hikes.
  • The Summary of Economic Projections (SEP) median is expected to show two rate hikes for the remainder of the year, rather than the three hiked called by the strategists.
  • Some SEP participants are projected to forecast a rate cut in 2025, contingent on how the Fed accounts for data revisions and potential lower growth.
  • Chair Powell is expected to deliver a resolute, hawkish tone at the press conference, avoiding a "dovish hike" which would likely cause the long end of the yield curve to sell off again.
  • Powell may cite the stickiness of the last few months of data as justification for the move, rather than admitting the urgency was driven by the long-end bond market sell-off.

Market Reaction and Yield Curve Dynamics

• The CPI release triggered a notable twist flattening of the yield curve, with front-end rates rising and longer-term rates declining immediately following the print.
  • Investors assign roughly a 90% probability to a 25 basis point hike next week.
  • The move suggests that a credible commitment to fighting inflation is viewed as supportive of lower long-term borrowing costs, reversing the sell-off seen after the July FOMC.
• Breaks across the yield curve have compressed, with inflation compensation declines being most pronounced in the front end.
  • The front-end move correlates strongly with the beta to falling oil prices.
  • The primary dynamic driving the curve is the flattening of real yields, particularly in the forward curve, where Bank of America maintains a preference for forward-starting real yield flatteners.
• Recent rate moves have been driven by three primary factors:
  • Policy Expectations: Markets are aligning the 2-year rate with Fed hiking paths.
  • Policy Uncertainty: Back-and-forth communications from Chair Powell regarding the response function have increased volatility.
  • Supply/Demand: Concerns regarding Treasury buybacks and the shifting buyer base toward Investment Grade (IG) sensitive funds have pressured the long end.

Treasury Buybacks and Long-Dated Spreads

• Recent Treasury buyback signals were deemed underwhelming by the market, as the calendar did not announce aggressive future sizes and Treasury did not purchase the maximum available yesterday.
  • Strategists view the current buyback size as too small to offset the duration risk being pumped into the market via large auction sizes.
  • The limited scope of buybacks suggests that meaningful intervention to reduce long-end supply will likely occur at the November refunding meeting.
• Treasury's entry as an active buyer is perceived as reducing tail risk for 30-year swap spreads, though vigilante risk remains in the 2-year spot market.
  • While the 5s30s spread curve has steepened and the 5s30s Treasury has flattened, strategists do not view the current buybacks as an abject failure.
  • There is a risk that if long-end buybacks prove ineffective, Treasury may be forced to adjust issuance at the back end of the curve in November.
• Market sentiment on stabilizing long-end rates is skewed heavily toward fiscal solutions:
  • 70% of survey respondents identified fiscal consolidation as the most realistic policy action to stabilize global long-end rates.
  • Only 20% of respondents cited a faster pace of central bank hikes as the primary solution.

Client Sentiment and Survey Data

• Bank of America's latest FX and Rate Sentiment Survey reveals significant skepticism regarding the Fed's communication strategy.
  • Over 80% of respondents believe Chair Powell's communications are ineffective in delivering desired monetary policy outcomes.
  • The survey indicates a relatively flat distribution of client views on the drivers of the global long-end rate move since June: roughly 30% attributed to hyperscaleless supply, 30% to improved growth, and 30% to other factors.
• Forward-looking views suggest that if inflation persistence continues alongside Fed hikes, the market may need to price in even more tightening to reach the Taylor Rule implied rate of 5.2%.
  • The first threshold of reversing prior rate cuts has been priced in; the next potential target is the peak of the last hiking cycle (low 5%).
  • A lack of negative feedback from financial conditions and continued inflation persistence would be required to justify rates moving beyond the current pricing.