US interest rates: more time for the Fed, but the market has already done the ‘dirty work’

A figure that is broadly in line with pre-release expectations is unlikely to bring about a significant and lasting change to the trends already underway in the markets. The marginal decline in US inflation – recorded in July at 3.4 per cent year-on-year in the headline figure and 2.5 per cent in the core figure, which excludes the most volatile components such as food and energy prices – is no exception and essentially leaves the door open for a possible interest rate rise by the Federal Reserve at its next scheduled meeting.

On paper, the implied probability of a further rate rise by the US Federal Reserve in September, as tracked by the CME’s FedWatch, has fallen from 50 per cent to 40 per cent following the release of the consumer price index, thus continuing the trend that began following last Friday’s disappointing labour market figures. Employment and inflation are, after all, the main issues that continue to divide the ‘hawks’ and ‘doves’ among Washington’s policymakers, and which are likely to shape the decision with their updates due before the 16th of the month, when the monetary policy decision will be announced.

There is no doubt, however, that the market has already, to a large extent, done, as they say, the ‘dirty work’ on the Fed’s behalf through a rise in bond yields, particularly for longer maturities. This development effectively acts as a tightening of financial conditions in its own right and allows Kevin Warsh and his colleagues to bide their time before possibly taking action.

This is confirmed by a thorough analysis of recent Treasury yield trends and the factors that have driven them. The nominal yield on the 10-year US government bond has been hovering around 4.65 per cent for the past few days. However, it was the real interest rate component – which rose to around 2.4 per cent – that pushed it to its highest level in over two years.

The particularly sharp rise seen from May onwards – of around 50 basis points – has effectively translated into a direct increase in borrowing costs for businesses and households, without the Fed having to lift a finger. The weak data from the labour market, as well as the cautious signals emerging from demand and the easing of price pressures in one of the sectors most sensitive to interest rate changes – the property sector – are, in essence, the most immediate consequences of this phenomenon, which has also been acknowledged by some members of the FOMC, including the Chair, who have spoken of a ‘significant tightening’ driven by the markets.