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The Federal Reserve and markets have long been at loggerheads over where interest rates are heading. There are mounting signs of an uneasy rapprochement now. This week, the markets implied odds on the US central bank following through with three or more interest rate increases this year finally crossed the 50% mark. In fact, the Fed funds futures market that underpins Bloomberg's interest rate probability calculator now even indicates a 15% chance of four quarter-point increases this year.
Although these misleadingly precise numbers mask some pretty messy underlying assumptions, there's undoubtedly been a sharp change of thinking among investors this year. Just a month ago, the implied odds of three interest rate increases or more was under 30%, despite the Fed's messaging.
The reassessment has been driven by rising economic optimism and core inflation actually surprising on the upside in December. And that has pushed the rate sensitive two-year Treasury yield above the 2% mark for the first time in a decade. The 10-year Treasury yield has also climbed to a nine-month high of 2.6%. But given the inflation reading, the hawkish European Central Bank minutes, and jitters around the Bank of Japan's bond buying programme, the relatively subdued sell-off indicates that chatter about a bond bear market is still premature.
It's worth noting that the rising inflation expectations account for almost all the move in the 10-year Treasury yield this year. The real inflation adjusted 10-year Treasury yield has largely been oscillating around the 1/2% mark since the ructions that followed the 2016 presidential election.
Short-term bond yields are likely to continue to edge higher as long as the Fed continues on its monetary tightening path and investors continue to believe in its plans. But long-end yields will probably need a proper inflation shock to be shaken out of their current stupor. As it happens, an inflation spurt followed by a bond crash was in a recent investor survey fingered as the single biggest risk confronting global markets. Nonetheless, it will take more than a mild one-off inflation surprise to precipitate that.