Stronger-than-expected U.S. inflation data has bond traders weighing

Stronger-than-expected U.S. inflation data for September has the bond market now considering the risk that the Federal Reserve may end up being forced to tighten interest rates into a stagnating economy with persistently higher price gains.

Consumer price readings have come in at 5% or higher on a year-over-year basis for five straight months, undermining the “transitory” theme put forward by central bankers. Bond traders reacted to Wednesday’s report by sending Treasury yields lower on maturities from seven years and out, causing the widely followed spread between two- and 10-year Treasury yields to narrow.

Wednesday’s market moves are important because they signal what some economists say is a profound shift that’s under way in the minds of traders and investors. Until recently, many had chosen to give the Fed the benefit of the doubt, siding with the central bank’s transitory narrative. But the post-CPI drop in Treasury yields — with the exception of rates between the 3-month bill and the 3-year note, which moved higher — included a surprising, temporary decline in the five-year rate
TMUBMUSD05Y,
1.077%
to as low as 1.047%, a yield that reflects what would presumably be the Fed’s entire, forthcoming rate-hike cycle.

The Dow Jones Industrial Average DJIA also dropped by around 100 points, or 0.3%, while the S&P 500 SPX was marginally lower, although the tech-heavy Nasdaq Composite Index
COMP,
+0.37%
was up by 0.4%

“The inflation numbers weren’t great and people think the Fed is not going to let inflation get out of hand,” said David Petrosinelli, a senior trader at InspereX in New York, in a phone interview. “Right now, there are a basket of things going on. One of them is that the Fed’s hand may be forced to unwind QE purchases faster than Chairman Jerome Powell would like. The policy error would be that the Fed has waited too long to hike, and may be forced to hike by too much.”

The data released on Wednesday showed consumer-price gains rising at a 5.4% year-over-year pace last month, above the 5.3% consensus estimate, and staying at a 30-year high. That’s more than double the Fed’s 2% target, and confirmed fears that many forecasters have been underestimating the underlying strength behind the recent surge of inflation. Echoing a similar sentiment on Tuesday was Atlanta Fed President Raphael Bostic, who said the rise in inflation should no longer be considered “transitory,” in an apparent break with other Fed leaders.

Minutes of the Fed’s Sept. 21-22 meeting will be released at 2 p.m. Eastern time, and may provide more details on policy makers’ statement last month that the tapering of $120 billion in monthly bond purchases “may soon be warranted.” Analysts expect a tapering announcement to come at the Nov. 2-3 gathering, with the entire process of pulling back on bond purchases likely to last for months.

The Fed has held the…