Due to the continuous decline of inflation in the United States, bond market investors have strengthened their bets that Fed officials will cut interest rates by 25 basis points in September.

Overall, traders on average expect that the Fed will cut interest rates by 32 basis points at its meeting in September. This is a decrease in expectations compared to the previous day, and the probability of a 50 basis point rate cut has been reduced to about one-third. U.S. Treasuries rose on Wednesday, pushing the yield on 5-year bonds to a lower level.

Traders expect the Federal Reserve to cut interest rates by nearly 25 basis points next month.

David Kelly, chief global strategist at JPMorgan Asset Management, said in a television interview that weak inflation data released on Wednesday "confirmed that the inflation problem is fading. CPI data close to expectations is an example of selling news-bond markets are experiencing this situation."

On Wednesday, the policy-sensitive 2-year US Treasury yield rose to 3.95%, while the yield on 5-year bonds steadily declined, with the 30-year bond yield falling 4 basis points. Open interest, the risk borne by futures traders, is consistent with the profit position of bond traders in the US Treasury market. Data released on Tuesday showed that the producer price index (PPI) in July rose less than expected, increasing their bullish bet.

In Wednesday's trading, the flow of options related to secured overnight financing rate (SOFR) reflected that traders are unwinding their bets on a 50 basis point rate cut. SOFR closely follows the Fed's policy path. Traders seem to have adjusted other dovish bets, narrowing the possibility of a 50 basis point rate cut, as pricing in the swap market tends towards a 25 basis point rate cut. Before their adjustments, the so-called core CPI, which excludes food and energy costs, rose 3.2% year-on-year in July, still the slowest pace since early 2021. This largely matches economists' expectations and keeps the Fed on track to cut interest rates soon.

Traders bet that US bonds will continue to rise, with open interest on 10-year US bonds approaching a record high.

Traders still expect the Federal Reserve to cut interest rates slightly more than one percentage point by 2024, with three policy meetings remaining this year. In recent trading days, market pricing has shown divergent expectations on whether the Fed will cut interest rates by 25 or 50 basis points next month.

More Wall Street insiders' interpretations

Lindsay Rosner, director of multi-sector fixed income at Goldman Sachs Asset Management, said the data (CPI) "cleared the way for a 25 basis point rate cut in September, but did not completely rule out the possibility of a 50 basis point rate cut". Thursday's release of weekly initial jobless claims and retail sales data will provide traders with another hint of what's to come, and they will pay close attention to Fed Chairman Powell's comments at the central bank's annual symposium in Jackson Hole, Wyoming later this month, as well as the next US employment report in early September.

Neil Sutherland, portfolio manager at Schroder Investment Management, said at the Jackson Hole central bank meeting, "They may refuse to acknowledge the more negative growth prospects." "We do see a weaker labor market," he said. As the market discusses the extent to which the Fed may cut interest rates in September," the labor market will give us a clearer picture. "

Chris Larkin of Morgan Stanley E*Trade said:"It may not be as cool as yesterday's (Tuesday's) PPI, but today's CPI is as expected and is unlikely to upset the status quo. The main question now is whether the Fed will cut interest rates by 25 basis points or 50 basis points next month. If most of the data over the next five weeks points to an economic slowdown, the Fed may cut rates even more."

Krishna Guha of Evercore said that CPI is not perfect, but it is good enough because it is consistent with the Fed's preferred inflation measures. In addition, the Fed has abandoned its dependence on data points and is focusing on a broader outlook and risk balance. He pointed out:"The Fed now is a labor market first Fed, not an inflation data first Fed, so future employment data will determine the extent of the Fed's interest rate cut."

Mark Hackett of Nationwide said that the easing of macro concerns is one of the factors that has improved the stock market backdrop. He pointed out that the pressure for a market downturn is a "gradually disappearing memory".

Strategists at Daiki Securities, led by Oscar Munoz and Gennadiy Goldberg, said the latest CPI report provided the conditions for a Fed interest rate cut in September.

For Chris Zaccarelli of Independent Advisor Alliance, July CPI data is "no news, good news" because the market has been tense and the Fed is seeking a rate cut-any content in this report should not prevent them from doing so.

Seema Shah of Principal Global Investors said that the CPI data eliminated any stubborn inflation barriers that may have prevented the Fed from starting an interest rate cut cycle in September. However, this number also indicates limited urgency for a 50 basis point rate cut.

Florian Ielpo, of Lombard Odier Investment Managers, said: "Apart from possibly supporting a rate cut due to concerns about the employment market, the CPI has provided almost no new information to guide the Fed's future decisions."

Anna Wong and Stuart Paul of Bloomberg Economics said:"The weak CPI report may slightly enhance the confidence of Federal Reserve officials in the decline of inflation. Although the core personal consumption expenditure (PCE) inflation data for July will not be so good, we expect the Fed to cut interest rates in September due to the rise in the unemployment rate."

Brian Rose of UBS Global Wealth Management said:"Inflation data has always been good enough for the Federal Reserve to start cutting interest rates in September, but it hasn't given them a reason for a big cut. Whether to cut 50 basis points instead of the usual 25 basis points may depend on the employment report in August."

Rose also pointed out that Thursday's retail sales data is another key data point, as the main downside risk to his soft landing assumption is a fallback in consumer spending.

Neil Sun, portfolio manager at Royal Bank of Canada Global Asset Management's BlueBay, said:"The US economy is still cooling down and the labor market has also shown some slowdown. However, we are not overly concerned about the risk of a US recession in the short term. If the potential trend of cooling inflation and a continued slowdown in the US economy continues, we are ready to take full advantage of any fluctuations."

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