Fixed income markets that seemed oblivious to the threat of inflation last year now are reacting to what looks to be an uncertain path of monetary policy amid the public’s discomfort with sustained inflation.
Both the futures market and the OIS market are now expecting the Federal Open Market Committee to hold off raising the Federal Reserve’s policy rate until its December meeting.
This is happening at the same time that the University of Michigan and the New York Fed measures of inflation expectations are anticipating inflation rates of greater than 3% over the next one to three years.
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Yet expectations around the July consumer price index report, which will be released on Wednesday, imply a 0.1% monthly increase in the top-line number that will be accompanied by a 0.2% rise in the core rate, which excludes the more volatile food and energy components.
Those increases will translate to a slower annual pace of inflation from one year ago, to 3.4% and 2.5% respectively.
And that will almost certainly result in diminished expectations of any rate cut this year.
Ordinarily, one would expect inflation expectations to have a tight relationship with the direction of Fed policy and the yield on 2-year Treasury notes, with the 2-year considered to be the present value of future federal funds rate settings.
When inflation expectations move higher, the 2-year yield would move in tandem, with the market expecting the Fed to hike its policy rate in response to the threat of inflation and its effect on household spending, economic growth and employment.
That relationship broke down in 2025, most likely because of the bond market’s uncertainty or perhaps because of the effect of tariffs on domestic prices.
That all changed with the closure of the Strait of Hormuz and the energy shock.
The 2-year interest rate jumped from 3.4% at the end of February to as high as 4.3% at the end of July.
The takeaway
The bond market, from the 2-year out to long-term bonds, is no longer pricing in a rate cut but is instead pricing in a minimum of one 25 basis-point rate hike and higher interest rates to compensate for the loss of real (inflation-adjusted) return on their investments.
This comes despite what seems to be a reluctance by the FOMC to react to the personal consumption expenditures index, the Fed’s preferred inflation gauge, which has been above its 2% target since February 2021 and has accelerated since April 2025.
The yield on 2-year Treasury notes moved from 3.4% in February to 4.3% in July, suggesting the bond market is no longer ignoring the threat of sustained inflation even if investors are poised to reduce the probability of any rate hike this year on the back of the July CPI.
If you’re not confused you’re not paying attention.
