U.S. Treasury yields broke a three-day run of declines on Wednesday, as crude oil prices jumped following a renewed flare-up in the Iran conflict, ahead of the Federal Reserve's interest rate decision later on.
Investors broadly expect the Fed to hold its main lending rate steady, though there is some scepticism. Money markets show traders still see a near 32% chance of a 25-basis-point rate hike, according to the CME FedWatch Tool.
"The labour market is not contributing to inflation, leading inflation indicators point to further cooling, and inflation expectations are broadly anchored. If the data continues to cool, peak hawkishness is behind us," BCA Research analysts said in a note.
Both one- and five-year inflation swaps have declined steadily over the past few weeks, suggesting investors see little chance of a sustained pick-up in price pressures over the medium term.
Data earlier this month showed U.S. job growth slowed sharply in June and payroll gains for the prior two months were revised lower, pointing to a cooling labour market, while consumer inflation slowed more than expected in June as crude oil prices retreated.
Traders are fully pricing in the chance of a September rate hike, along with a 71.2% chance of an additional hike by year-end, according to LSEG-compiled data.
Wednesday's interest-rate decision will be the second meeting for Kevin Warsh in his capacity as chair. Analysts expect the central bank to hold back on any forward guidance on rates after Warsh last month delivered a shortened policy statement, in contrast to former Chair Jerome Powell.
"This is the most uncertain that the market has been on whether the Fed will change rates going into a meeting since December 2018," Jim Reid, global head of macro research at Deutsche Bank, said in a note.
The yield on the benchmark U.S. 10-year note inched 1.2 basis points higher to 4.616% and the one on the 2-year note, which most closely tracks changes in interest rate expectations, rose 2.4 basis points to 4.301%. Both were on pace to snap a three-day streak of declines.
On Wednesday, crude oil prices rose more than 3% after sliding for the previous three sessions, after the U.S. and Saudi Arabia launched strikes on Iran-backed groups in Iraq, raising concern about the conflict widening and further restricting energy flows from the region.
Treasury yields are below this month's highs, but are still on course for a strong rise in July, as investors have ramped up their bets on interest-rate hikes, given the spike in oil prices and the possible impact on inflation.
The yields on 10-year and 30-year notes are set for their biggest monthly jump since March, while the 2-year yield is headed for a fifth straight monthly rise.
On the economic data front, the June U.S. Personal Consumption Expenditures Price Index, which has typically been the Fed's favoured measure of inflation, lands on Thursday, along with a second-quarter GDP reading.
Meanwhile, supply for Treasuries was plentiful this week with auctions of 2- and 5-year maturities on Monday. On Tuesday, a $44 billion auction of 7-year notes was seen as mediocre, with demand of 2.49 times the notes on sale roughly even with the average, according to analysts.
