U.S. yields surge after CPI surprises to upside in August

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By Herbert Lash

NEW YORK (Reuters) -U.S. Treasury yields surged and a closely watched inversion of the yield curve widened on Tuesday after monthly U.S consumer prices unexpectedly rose in August, signaling to the market that the Federal Reserve will crack down further on inflation.

The yield on two-year Treasury notes, which typically reflects interest rate expectations, jumped to a fresh 14-year high of 3.752% in a move that widened the gap with the benchmark 10-year Treasury note.

Market rates were declining before the report on consumer prices on expectations headline inflation had peaked and that even though the Fed was expected to hike another 75 basis points when policymakers meet next week, it would soon pull back.

The consumer price index gained 0.1% last month after being unchanged in July, while the 12 months through August the CPI increased 8.3%. Economists polled by Reuters had forecast the monthly CPI dipping 0.1% and year-over-year rising 8.1%.

"Inflation is public enemy No. 1 for the Fed, and I think this number puts pressure on them to continue," said Priya Misra, head of global rates strategy at TD Securities.

"We get a fairly hawkish message out of that September Fed meeting, and that’s what the market is pricing in if you look at today's massive move higher in rates," Misra said.

The Fed's terminal rate could rise to the mid-4% range before rates start declining, she said. The market before Tuesday had expected that rate to top at about 3.75%, if not lower.

Fed fund futures were pricing in a 17% probability that the Fed will raise interest rates by 100 basis points (bps) at the end of policymakers' two-day meeting Sept. 20-21. Misra doubted the Fed would go that high, but said 75 bps in November was possible.

The yield on 10-year Treasury notes rose 7.7 bps to 3.439%, while the gap between yields on two- and 10-year notes, seen as a recession harbinger, was at -30.2 basis points.

"The curve can be even more inverted, because the front end keeps moving higher due to inflation," Misra said. "But the economy’s ability to handle the rate hikes, we haven’t become more resilient on that front."

The breakeven rate on five-year U.S. Treasury Inflation-Protected Securities (TIPS) was last at 2.612%.

The 10-year TIPS breakeven rate was last at 2.447%, indicating the market sees inflation averaging about 2.5%% a year for the next decade.

The U.S. dollar 5 years forward inflation-linked swap, seen by some as a better gauge of inflation expectations due to possible distortions caused by the Fed's quantitative easing, was last at 2.435%.

Sept. 13 Tuesday 10:10 AM New York / 1410 GMT

Price Current Net

Yield % Change

(bps)

Three-month bills 3.165 3.2351 0.083

Six-month bills 3.645 3.765 0.179

Two-year note 99-23/256 3.735 0.164

Three-year note 99-78/256 3.7472 0.148

Five-year note 97-242/256 3.5805 0.122

Seven-year note 97-124/256 3.5357 0.100

10-year note 94-68/256 3.437 0.075

20-year bond 94-24/256 3.8003 0.046

30-year bond 89-208/256 3.5558 0.043

DOLLAR SWAP SPREADS

Last (bps) Net

Change

(bps)

U.S. 2-year dollar swap 33.50 0.50

spread

U.S. 3-year dollar swap 11.25 1.00

spread

U.S. 5-year dollar swap 5.00 -0.50

spread

U.S. 10-year dollar swap 6.00 -0.50

spread

U.S. 30-year dollar swap -32.50 -0.25

spread