By Davide Barbuscia

NEW YORK (Reuters) – The Federal Reserve’s aggressive start to the easing cycle has rekindled inflation worries in the U.S. bond market, as some investors fear that looser financial conditions could reignite price pressures.

Yields on longer-dated Treasuries that are most sensitive to the inflation outlook have risen to their highest since early September. This has raised concerns that the Fed’s shift in focus from combating inflation to protecting the job market could lead to a rebound in price pressures.

“I think there are questions about how quickly inflation will reach the Fed’s target if we’re in a cutting environment, and if we’re in an environment where the Fed wants to support the labor market before it weakens,” said Cayla Seder, macro multi-asset strategist at State Street (NYSE:STT) Global Markets. She expects long-term yields, which rise when prices fall, to climb further as the market bets on stronger growth and inflation.

Fed Chair Jerome Powell mentioned last week that the 50 basis point interest rate cut that initiated the U.S. central bank’s descent was a “recalibration” of rates aimed at maintaining strength in the labor market while ensuring inflation moves sustainably toward the Fed’s 2% goal.

The Fed’s emphasis on economic resilience has fueled concerns that the path to lower rates could be slow and bumpy. Fed officials’ forecasts on interest rates also suggested a more gradual pace of cuts than what the market anticipated.

Expectations for inflation over the next decade, as measured by Treasury Inflation-Protected Securities (TIPS), increased post-Fed’s announcement on Wednesday, with the 10-year breakeven inflation rate rising to 2.16% on Thursday, its highest since early August. It reached 2.167% on Monday.

An auction of 10-year TIPS on Thursday following the Fed’s rate-setting meeting attracted strong investor interest, with non-dealers absorbing 93.4% of the $17 billion Treasury debt sale, the highest share since January. However, flows into U.S. dollar inflation-linked bonds were negative in the week ending Monday, according to LSEG data.

“Investors are once again concerned with the specter of reflation,” noted BMO Capital Markets rates strategists. Fund manager Matt Smith at Ruffer has been adding inflation protection to his portfolio via commodities and commodity equities, which are considered classic inflation hedges, and currently trading at extremely low valuations.

Many market participants recall the selloff that occurred when a dovish pivot by the Fed in December was followed by months of unexpected inflation and employment gains.

The Goldman Sachs U.S. financial conditions index, a measure of credit availability, eased during the year despite interest rates being at their highest in over two decades. Following the Fed’s decision, it fell to its lowest level since May 2022.

“We think inflation will remain relatively benign … but the more aggressively the Fed cuts, the more you have to question that,” said Brendan Murphy, head of fixed income for North America at Insight Investment.

FED PUT

Inflation, as measured by the U.S. Consumer Price Index, declined significantly over the past two years, standing at 2.5% in August, down from an over 40-year high of 9.1% in June 2022.

Fed Governor Christopher Waller indicated last week that recent data led him to believe the Fed needed to accelerate rate cuts to avoid undershooting its 2% inflation target.

Conversely, Fed Governor Michelle Bowman expressed concerns that a larger cut could be seen as “a premature declaration of victory” over inflation. She dissented against the recent half-percentage-point cut, favoring a quarter-percentage-point reduction instead.

Should inflation continue to decline, the outlook for bonds may remain positive, despite the volatility tied to changing expectations for interest rate cuts.

However, some question whether the central bank’s aggressive cut was premature, as inflation is still above target and recent monthly data indicated persistent price pressures.

Discussing the “Fed put” – the perceived inclination of the central bank to aid financial markets – economists at BofA Securities remarked that the “Powell put” came too early considering economic resilience and the stock market’s record highs. “A more aggressive easing cycle could make reaching the 2% target harder,” they stated.