The US Treasury yield curve flattened to two-and-a-half month lows on Thursday as investors adjusted for the likelihood of a December interest rate increase, a day after the Federal Reserve struck a more-hawkish-than-expected tone at its September meeting. New economic projections released after the Fed's two-day policy meeting showed 11 of 16 officials see the "appropriate" level for the federal funds rate, the central bank's benchmark interest rate, to be in a range between 1.25 percent and 1.50 percent by year-end.
"The meeting was definitely more hawkish than what the market was anticipating," said Mary Ann Hurley, vice president in fixed income trading at D.A. Davidson in Seattle. "We were definitely not pricing in another rate hike for this year." The yield curve between Treasury five-year notes and 30-year bonds flattened to 92 basis points on Thursday, the lowest level since July 6. Intermediate-dated debt is highly sensitive to interest rate increases, helping them underperform, while longer-dated bonds are influenced by inflation expectations.
Some traders and investors had expected the Fed to strike a more dovish tone given the potential economic impact of recent severe hurricanes and still sluggish inflation. The US central bank was also seen as potentially slowing its rate hike path to give the market time to absorb reductions in its balance sheet.
Personal income data released on September 29 will be the next major focus for signs of whether inflation is picking up. "I have a hard time seeing how if we don't get an uptick in the PCE core and some kind of move higher in the real neutral fed funds rate between now and the end of the year, that they're going to stand pat this year," said Lou Brien, a market strategist at DRW Trading in Chicago.
The core personal consumption expenditures (PCE) index, which excludes food and energy prices, is the Fed's preferred measure of inflation. The Treasury Department saw soft demand for a $11 billion sale of 10-year Treasury Inflation-Protected Securities (TIPS) on Thursday, which sold at yields more than 2 basis points higher than they had traded before the auction. Data on Thursday showed that manufacturing activity in the mid-Atlantic region accelerated in September amid a surge in new orders.