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Bond investors expect smaller Fed rate hike but brace for inflation shocks

FILE PHOTO: An eagle tops the U.S. Federal Reserve building's facade in Washington

By Davide Barbuscia

NEW YORK (Reuters) - The U.S. Federal Reserve's likely shift to a smaller interest rate increase this week could offer some respite to bond investors hit hard by a string of super-sized hikes, though questions remain on how much damage the Fed is ready to inflict on the economy.

The central bank has embarked on the fastest tightening of monetary policy in 40 years to contain the biggest jump in inflation in decades, but Chair Jerome Powell said last month that after four consecutive 75 basis points increases the pace of rate hikes could slow in December.

The less aggressive stance - which followed better-than-expected consumer price data in October - fueled a bond rally over the past month. Benchmark 10-year Treasury yields have declined to about 3.5% from over 4% in early November, and two-year Treasury yields - which tend to closely reflect monetary policy expectations - are down to 4.3% from a 15-year high of 4.8% early last month.

Fresh data on inflation will come with the release of the November Consumer Price Index on Tuesday, one day before the Fed's policy decision will be announced. The rate of price increases has recently shown signs of slowing but CPI could jolt markets once again if inflation surprises on the upside.

"I think the CPI numbers are potentially a more important event ... given it has been an important pillar in the building narrative of being close to a peak in the fed funds," said Martin Harvey, portfolio manager of the Hartford World Bond Fund.

On Friday a report from the Labor Department showed underlying producer prices increasing at their slowest pace since April 2021 in November, on a year-on-year basis. While overall producer prices rose slightly more than expected, the trend is moderating.

Fed funds futures traders on Friday were pricing in a 93% probability of a 50 basis points rate hike this month, which would bring the Fed's policy rate to a 4.25%-4.5% range.

Lynda Schweitzer, portfolio manager and co-head of the global fixed income team at Loomis, Sayles & Company, said that while she was confident about the Fed's downshift to a 50 basis points hike, her focus was more on potentially higher CPI data as well as surprise decisions from other central banks.

"The ECB (European Central Bank) is more of a wild card to me, and the CPI print will be interesting if it confirms this turnover. If we get another surprise higher ... the market would be risk off again," she said.

'DISCONNECT'

Investors will also focus on how firm the central bank will be in reiterating that interest rates are likely to remain high after reaching their peak. Fed officials have already emphasized this prospect, and new projections from the Fed this week are likely to show rates continuing to rise and to remain elevated through 2023.

As of September, Fed's policymakers saw the fed funds rate ending 2023 at 4.6%. Chair Powell said last month the so-called terminal rate would need to be "somewhat higher," and other Fed officials have discussed rates possibly rising above 5% next year.

Money market investors expect the Fed will keep increasing rates over the next few months to a peak of 4.96% by May next year - down from 5.15% at the beginning of last month - but they project rate cuts in the second half of next year, betting the Fed will try to boost an economy bruised by much higher borrowing costs.

"There is a disconnect between what the market is pricing versus what the Fed is saying," said Jim Caron, chief fixed income strategist at Morgan Stanley Investment Management.

He expects bond volatility to subside going forward as the Fed gets closer to the end of its hiking path, but added that Treasury yields could still go higher, depending on inflation.

"I'm not so convinced that the Fed is going to cut rates in the next year or so. Therefore, I have to believe that 10-year Treasury yields are probably too low," he said.

(Reporting by Davide Barbuscia; Editing by Alden Bentley and Andrea Ricci)