The bond market is bracing for a crucial consumer price index (CPI) report on Wednesday, which could further erode confidence in the Federal Reserve's ability to cut interest rates over the next year. Treasury yields have resumed their rise, with two-year yields reaching the highest level since July, as investors anticipate the potential impact of the upcoming inflation data.

Investors Brace for Pivotal CPI Report Amid Shifting Rate Expectations

Yields Climb as Investors Prepare for Inflation Data

The bond market has seen a resurgence in yields, with two-year yields reaching their highest level since July. This move reflects the growing concern among investors about the potential impact of the upcoming CPI report on the Federal Reserve's monetary policy decisions. The selloff in Treasury futures on Monday, when the cash market was closed for Veterans Day, has also contributed to the rise in yields.The increase in yields has been further fueled by a slate of corporate bond issuances on Tuesday, which is on pace to be the largest in two months with at least 13 offerings. This activity has defied signs that record-high levels for US equity benchmarks are stoking demand for bonds, as evidenced by the record inflows at exchange-traded funds that aim to benefit from bond-market gains last week.

Inflation Concerns Loom Large

According to David Rogal, fixed-income portfolio manager at BlackRock Inc., the bond market is "set up for a stronger CPI number." Rogal believes that even with certainty on the election result, there is still a fair amount of uncertainty on policy and how that will impact the markets.In Rogal's view, the front end of the yield curve has already made a substantial adjustment, and he believes it is now very close to fair value. This sentiment is echoed by Scott Kleinman, co-president at Apollo Global Management Inc., who stated in a Bloomberg Television interview that "inflation is not tamed" and that "we're going to have to live with a higher rate environment for a lot longer."

Fed's Messaging Adds to Uncertainty

The bond market's reaction also reflects the mixed messaging from the Federal Reserve. Richmond Fed President Thomas Barkin reiterated the message that Fed Chair Jerome Powell delivered last week after policymakers cut interest rates by a quarter point.Barkin outlined two potential scenarios for the economy: As election uncertainty fades, companies could begin investing and hiring again, leaving the Fed to focus on upside inflation risks. Alternatively, companies could respond to margin compression from weaker pricing power by firing workers, which would elevate employment risks for the Fed.Investors appear to be responding to "the Fed's recent comments suggesting that cuts could be more gradual," according to interest-rate strategists at TD Securities. This uncertainty has led to a rise in longer-dated yields, which are unlikely to increase as much under a scenario of more gradual rate cuts.

Diverging Expectations on the Yield Curve

While the election results have certainly increased economic uncertainty over the next couple of years, Nate Hyde, portfolio manager at Insight Investment, believes this is not something the Fed can react to on a proactive basis.Hyde expects inflation and employment conditions to weaken, allowing yields in the two- to five-year part of the bond market to decline. This contrasts with the view that the front end of the curve has already made a substantial adjustment and is close to fair value.The diverging expectations on the yield curve reflect the ongoing debate among investors and policymakers about the path of inflation and the appropriate monetary policy response. As the market eagerly awaits the CPI data, the bond market's reaction will be a crucial indicator of the market's confidence in the Fed's ability to navigate the current economic landscape.