Following a higher-than-expected core inflation reading, traders have intensified their bets on a Federal Reserve interest rate hike. Markets now assign a 90% probability to a rate increase at next week's policy meeting, with two hikes fully priced in by year-end.

Interest rate swaps indicate that traders have raised their expectations for higher benchmark rates in the coming months, as persistent price pressures may compel policymakers led by Fed Chair Kevin Warsh to act. David Rees, Global Head of Economics at Schroder's, noted that the Fed is already behind the curve. He explained that the central bank can either opt for a hike next week to manage short-term borrowing costs in a controlled manner, or refrain from acting and risk uncontrolled increases in long-term borrowing costs. The Labor Department reported on Friday that the core consumer price index, excluding food and energy, rose 0.3% month-over-month in August, exceeding forecasts, with an annual increase of 2.4%. The yield on the policy-sensitive 2-year Treasury note initially climbed 7 basis points to 4.66%, the highest level since the start of 2024, before paring those gains. Meanwhile, the 10-year Treasury yield fell 5 basis points to 4.91%, after touching 4.98% earlier. The outperformance of longer-dated, inflation-sensitive bonds relative to shorter maturities suggests traders expect tightening policy to eventually dampen growth and price pressures.

This price action follows one of the worst single-day performances for Treasuries this year on Thursday, when surging oil prices pushed yields to multi-year highs. Traders noted that Thursday's selloff had already priced in the possibility that the CPI report would solidify the case for a September hike, thereby limiting Friday's market reaction. The broader Treasury index dropped 0.6% on Thursday, its steepest decline since March 20, with rising energy costs also dragging down UK gilts that day.

Inflation Remains Sticky

The latest report highlights that progress toward the Fed's inflation target remains limited, impacted by higher energy costs stemming from the Iran conflict, tariffs, and data center construction. Warsh has been cautious about signaling the central bank's next move, but stated last month that if inflation fails to cool "quickly enough," the Fed "still has work to do." Win Thin, Chief Economist at Bank of Nassau 1982, remarked that this data does not appear to meet the criteria Warsh has set for returning inflation to 2%, and he anticipates a rate hike next week. With markets nearly fully pricing in an increase, Thin added that "the market is forcing the Fed's hand." US Treasuries and global bond markets have faced significant pressure in recent months. Escalating hostilities in the Middle East have pushed Brent crude above $100 per barrel, while concerns over US fiscal spending and deficits persist. The 10-year Treasury yield has risen 14 basis points this week, hovering just below the psychologically significant 5% threshold, a level not breached since 2007 except for one instance. Germany's 10-year yield also climbed to its highest since 2009, following the European Central Bank's second rate hike since the conflict began in late February.

Paving the Way for Action

With just days remaining until the Fed's meeting, this CPI report is viewed as removing a key obstacle to a rate hike. Fed Governor Christopher Waller indicated last week that this week's inflation data would "significantly influence his decision." Ian Lyngen, Head of US Rates Strategy at BMO Capital Markets, wrote that the report clears the path for the FOMC to hike next week, with expectations for at least one more 25-basis-point increase before year-end. He noted that short-end weakness alongside gains in longer-duration bonds is a rational price response, as the Fed's credibility is pulling down forward inflation expectations. Friday's rebound in long-term Treasuries offered some relief to Treasury Secretary Scott Bessent, who has been attempting to curb the broader bond selloff ahead of midterm elections. This week's expansion of Treasury buyback operations has not measurably shifted the trend. Bessent has downplayed concerns over rising yields, asserting that the Treasury market is in "very good shape," citing robust demand at recent auctions and the relative performance of US debt versus global peers. Thursday's auction of $22 billion in 30-year bonds saw historically strong demand, indicating that higher yields are attracting buyers.

Investors should closely watch the central bank's decision next week, as the outcome will likely set the tone for fixed-income markets in the near term.