(Bloomberg) — The fate of the world’s biggest bond market is hanging largely on a single question: Has inflation in the US already peaked? 

As traders attempt to determine whether the Federal Reserve should continue with aggressive interest-rate increases or allow for flexibility if there is enough economic slowdown to stop the sharpest rise in inflation in 40 years, Treasury yields have been swinging back and forth. 

The Friday release of the May consumer-price index report may help clarify the outlook, potentially holding the key to whether the benchmark stages another retreat or retests May’s high by pushing back over the psychologically key 3% level. It flirted with that Friday, when the yield rose as much as 8 basis points to 2.98% after the monthly jobs report underscored the economy’s continued strength. 

The Fed raising its target interest rate by half-percentage points at its June, July and July meetings is a certainty for swaps contract holders. Wages have risen steeply in a tight labor market. But there’s still no strong consensus on whether policymakers will continue that pace at the September meeting or enact a quarter-point move, a step they may take if they’re worried about driving the economy into a recession or feel confident inflation is coming down. 

“The jury is still out in terms of the inflationary trajectory,” said Jeffrey Rosenberg, senior portfolio manager for systematic multi-strategy at BlackRock Inc (NYSE:)., said on Bloomberg Television. “You can’t really get the Fed out of the business of focusing on the number one priority — of getting inflation down — until you really start to see that definitively show up. Until that happens, it’s going to be a very tough time.”

This uncertainty is increasing the likelihood that Treasuries will remain volatile over the coming days, as well as possible liquidity pressure. Also this week, the Treasury will hold its first auctions since the Fed has decided to stop reinvesting the proceeds of some of its maturing debt, another tool it’s using to tightening financial conditions. 

The Labor Department’s May report that US companies hired faster than expected in May saw Treasury yields rise across the board. Also, the Labor Department reported that hourly average earnings rose 5.2% to $5.25 from one year prior. That’s slightly less than April’s 5.5% but still far above pre-pandemic levels. The May CPI figure is forecast to show an annual increase of 8.3%, matching April’s pace and down from as much as 8.5% in March.

But there are signs of faith in the Fed’s ability to rein it in. Inflation expectations are being lowered as the Fed’s tightening of monetary policy has seen higher yields ripple throughout the financial sector. This has led to real rates or adjusted for the expected rate of inflation rising above zero from deep negative territory.

“The jobs data was aligned to more of a soft-landing story,” said Alan Ruskin, chief international strategist at Deutsche Bank AG (NYSE:). However the risk is that inflation stays sticky and lags a slowing economy, he said, a “dilemma that policy officials wish to avoid but which appears likely.”

After being 3.1% as early April, the 10 year breakeven rate which measures expected inflation using the difference between inflation-protected Treasury yields and nominal Treasury yields, is now at 2.75%.

Kathy Jones is chief fixed income strategist Charles Schwab (NYSE:) & Co., which manages over $7 trillion in total assets, says those expectations should remain in check as long as the Fed continues to follow through on its promise to tame consumer-price increases.

Fed speakers “are all almost repeating the same script — that bringing inflation down is job one,” Jones said. “As long as they talk the talk and walk the walk, long-term inflation expectations will stay pretty well anchored.” 

Although she expects to see half-point increases in June and July, before the Fed reduces the size of its increases in August, she believes that a strong CPI report will likely increase speculation about a move of 50 basis points in September.

Separately, the week’s upcoming auctions will be the first affected by the Fed’s balance-sheet reduction plan. The Fed will not reinvest the $15 billion Treasury debt due on June 15 in those auctions that settle the same date, but instead, the bank will invest only $5.6 billion. 

The Fed’s reinvestment purchases are done with so-called auction add-ons, which reduce the amount the Treasury has to borrow from the public. While for now that lost Fed support won’t require the Treasury to sell more debt since out-sized tax revenue has reduced the deficit, strategist anticipate that the Fed’s reduced hand in the marketplace will hurt liquidity and boost volatility.

A potential sale of corporate debt from Oracle Corp (NYSE:). The $28billion acquisition is likely to stimulate volatile hedging activities.

“You have a market that might not be able to withstand some of the run-off that we are going to have,” said Ira Jersey, chief US interest-rate strategist at Bloomberg Intelligence, referring to the Fed’s balance sheet reduction. “So you are going to see significantly higher volatility in rates markets.”

What to Watch

• Calendar:
  • June 7:  Trade balance; consumer credit
  • June 8: MBA mortgage application; wholesale trade
  • June 9th: Unemployment claims. Bloomberg June US Economic Survey. Household net worth
  • June 10: Consumer prices; real average hourly earnings; University of Michigan sentiment/current conditions/expectations; monthly budget statement
• Due to the pre-FOMC standard meeting silence period, Fed calendar is now empty
• Auction calendar:
  • June 6, 2013: The 13- and 26 week bills
  • June 7: 3-year notes
  • June 8: 10-year notes reopening
  • June 9, 4-week and 8-week bills and 30-year bonds reopening

©2022 Bloomberg L.P.