On Tuesday, the market displayed a calm demeanor ahead of the Federal Reserve's policy decision, with bond yields experiencing a slight increase. Traders anticipate the Federal Reserve's Wednesday policy announcement, leaving benchmark bond yields almost unchanged, just a few basis points short of a 16-year high.
The recent surge in oil prices to a 10-month peak and robust economic data exceeding expectations have sparked concerns about potential inflationary pressures. These factors have pushed yields up over the past few weeks. The CME FedWatch tool indicates that markets are almost certain (with a 99% probability) that the Fed will maintain interest rates within the 5.25% to 5.50% range after its meeting on September 20.
However, expectations for a 25 basis point rate increase in November, taking the range to 5.50% to 5.75%, have diminished from 41% to 31% over the last week. The 30-day Fed Funds futures suggest that it's unlikely for the central bank to lower its Fed funds rate target back to around 5% before August 2024.
Tuesday's economic agenda in the U.S. includes updates on housing starts and building permits. Additionally, the Treasury plans to auction $13 billion worth of 20-year bonds on the same day.
Alex Pelle, U.S. economist at Mizuho, emphasized that investors' focus on Wednesday would be directed towards the Federal Reserve's Summary of Economic Projections (SEP) and its dot plot of expected interest rates. He highlighted a significant discrepancy between market expectations and the 'dot plot'. According to market pricing, the Fed is expected to eventually restore its policy rate to the 3.75-4.00% range. However, the latest 'dot plot' indicates that the Fed plans to reduce rates to 3.25-3.50% by the end of 2025, and further to 2.5% over an unspecified period.
Pelle suggested that these projections underscore the market's sensitivity towards potential growth and inflation risks. He warned that any unexpectedly dovish tone in the SEP or post-meeting press conference could result in a further uptick in long-term rates, considering the current Treasury supply backdrop.
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