Treasury yields jumped and bonds fell this week as investors bet that a Fed interest rate hike would come this month. New York Fed President William Dudley – one of the most influential U.S. central bankers, and usually considered a dove – said late Tuesday that the case for tightening monetary policy had become “a lot more compelling,” while San Francisco Fed President John Williams said he saw “no need to delay” raising rates. Market-based odds of a ¼ percent Fed rate hike in March jumped from 40% to 76% in two days (see chart).

Source: Bloomberg

A rate hike is “more compelling” because inflation is rising. Although the Fed’s preferred inflation measure, core personal consumption expenditure (PCE) deflator, is still below the Fed’s 2% target, overall inflation pressures are building:

• CPI inflation rtes: core 2.27%, total 2.5%
• PCE price deflator: core 1.74%, total 1.89%
• University of Michigan survey’s 1-year inflation expectation: 2.7%

Longer-term Treasury yields remained range-bound this year, with the 10-year yield rebounding to the top of the range at 2.49% today. Longer-term Treasury yields typically exceed inflation over longer periods. As I outlined in our year-end 2017 outlook, we expect the 10-year yield to rise to around 2.8%, which would mean low to negative returns for long-term bonds.