Trading Desk Talk

Hot, Hot, Hot

Autumn may be approaching, but Federal Open Market Committee (FOMC) members appear reluctant to leave the summer dance floor, forming a conga line of sorts as the temperature — and inflation — stays hot. Cue Buster Poindexter and His Banshees of Blue: “See people rocking, hear people chanting, feeling hot, hot, hot.”

Markets certainly felt the heat last week, when September’s inflation report sent yields soaring from 5.18% to 5.33% in just 30 minutes. Calmer heads eventually prevailed, though, and the Treasury reclaimed its pre-report yield by the end of the day. The takeaway, however, is that inflation is not dissipating fast enough.

The Treasury market was buoyed for the remainder of the week by a flight-to-quality bid, as investors rotated out of the tech sector amid concerns about the profitability of massive AI-related capital expenditures. Still, the underlying fundamentals remain challenging and will return to the spotlight once the AI dust settles. Unfortunately, the Federal Reserve entered its media blackout period Saturday ahead of the upcoming October 27–28 policy meeting.

As September’s inflation report showed, the headline Consumer Price Index (CPI) rose 0.6% in September, marking the third consecutive monthly increase (Figure 1). Core CPI increased 0.3%, slightly above the 0.2% consensus and matching August’s pace. On a year-over-year basis, headline and core inflation stood at 3.7% and 2.6%, respectively. The report highlighted how inflation remains stubborn, but it did not materially shift expectations for the Fed’s October meeting.

Figure 1: Contributions to month-over-month CPI, seasonally adjusted, 2022–present

Source: Bloomberg

Top Fed officials — including Vice Chair Philip Jefferson, Governor Christopher Waller, and New York President John Williams — already signaled that the central bank was in no rush to hike again after raising rates in September for the first time since 2023. Williams, for example, said: “I haven’t changed my view that it may be appropriate to have one more rate hike [in 2026] … at this time I [don’t] have any reason to believe that we would need to do more [in 2027].”

Williams also expects inflation to slow “quite a bit” toward the Fed’s 2% target next year, as the effects of tariffs and higher energy prices fade. Although the AI infrastructure buildout could create near-term price pressures, Williams argued that underlying inflation is still cooling. “I still believe there’s disinflationary forces at play,” he said, while also acknowledging that the timing of any AI-related productivity gains remains highly uncertain.

Vice Chairs Jefferson and Michelle Bowman delivered a similar message earlier this month, arguing that policymakers should take more time before deciding whether additional tightening is needed. Jefferson, for instance, acknowledged that inflation has remained too high for too long, but said the Fed must weigh a series of economic shocks and carefully assess incoming data. “Any future adjustments in policy should be determined by carefully examining trends in the data, the evolving outlook, and the balance of risks,” he said. Bowman, meanwhile, was more direct: “I don’t currently see an urgent need for further action, and I think we need to better understand the totality of the data.”

Market participants reached the same conclusion. “I think this [CPI] print moves October from a tail risk to a real conversation,” said Jamie Patton of TCW Group. “But I still think recent rhetoric from [Fed officials] Williams and Jefferson makes an October hike unlikely.” Guy LeBas of Janney Montgomery Scott agreed: “We’d need a more convincing print to get so many of the ‘go-slow’ FOMC participants on board with a hike this month.”

However, a number of other Fed officials — including Cleveland President Beth Hammack and Dallas President Lorie Logan — believe that more than one additional move will be required to bring inflation back to 2%. “One gets the sense that doves on the committee got a cold cup of coffee when they opened up the September CPI data,” said Joseph Brusuelas of RSM US LLP. “The depth and breadth of the triple supply shock is clearly working its way through the American economy.”

Figure 2 shows that the market broadly seems to be siding with the doves and has priced in a pause in October. Nevertheless, the odds of a December hike are rising.

Figure 2: Market-implied probabilities of federal funds rate target ranges, October and December 2026

Source: CME Group

The finale of the week was Fed Chairman Kevin Warsh’s comments before the blackout period. Warsh said that “the world has broadly conformed to our expectations” since the FOMC’s last meeting in September. “We made very clear that we would deliver price stability, and we removed a dose of accommodation about a month ago … I don’t prejudge meetings. I don’t believe in saying now what I might do at the meetings that we have in the balance of this year.”

The market took Warsh’s comments to mostly cement the non-hike at the central bank’s upcoming meeting. The odds of a hike, which were hovering around 27% before Warsh spoke, dropped below 15% following his remarks. “It was clear that he wasn’t going to deliver anything that the market could latch on to as hawkish,” wrote Derek Tang of Monetary Policy Analytics. Warsh may also be emboldened to stay in the pause camp, because while the headline figures were hot, his own preferred metric indicated some cooling in broader inflation. Remember in his Jackson Hole speech, he mentioned the six-and 12-month measures of this metric as “trends” he cares about.

Figure 3: Core PCE and Breadth of Inflation

The bottom line is that September’s inflation report was not hot enough to force policymakers off the sidelines in October, yet it was firm enough to make an extended pause increasingly uncomfortable. For now, the doves remain at the front of the FOMC conga line, willing to give restrictive policy more time to work, while the hawks warn that stubborn inflation may require another turn on the dance floor.

Markets, for their part, have largely dismissed an October hike. However, the debate is already moving toward December, and each new inflation report carries greater potential to change the current tune. Autumn may have arrived, but for the Fed, inflation remains hot, hot, hot.

FROM THE DESK

Agency CMBS — Treasuries rallied last week on a flight to quality. Ginnie Mae project loans were flat to 1 basis point wider, while DUS spreads were largely flat. Buydowns are still popular, but seem to be widening, certainly below the 5.75% level. The large DUS trade still benefits from buydown and full-term IO. Loans under $10 million are now considered small and much tougher to trade in secondary markets, leading to wider spreads in new issue.

Municipals — Municipal bonds posted one of their strongest weeks since April, with AAA tax-exempt yields declining across the curve and some maturities rallying by more than 20 bps. The improvement in market conditions encouraged several previously delayed issuers to enter the market. While benchmark yields moved materially lower, spreads on short-term, cash-collateralized bonds and M-TEB transactions remained relatively stable. Investor demand also strengthened, as municipal bond mutual funds attracted $1.6 billion of net inflows for a second straight week, including $540 million into high-yield strategies.

ECONOMIC CALENDAR FOR THE WEEK AHEAD

Source: Bloomberg. P = preliminary; F = final

Source: Bloomberg

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