What the Inflation Numbers Mean for Bonds. Investors Should Be Happy.

Inflation was slightly lower than expected in July. Above, a man stocks shelves at a grocery store in Brooklyn in New York City. (Spencer Platt/Getty Images)

The latest inflation report should have bondholders breathing a sigh of relief. With price increases holding steady in July, the Fed’s long-hoped- for rate cut remains on track, giving a potential lift to bond prices.

On Tuesday, the Bureau of Labor Statistics reported that inflation was 2.7% year over year in July, matching the pace from June. That was slightly lower than the 2.8% economists expected, partly because energy prices declined.

Stock prices jumped on the news, but bond investors should be cheering too. Softer-than-expected inflation means the Federal Reserve is all the more likely to cut short-term interest rates following its next meeting in mid-September. And the longer-term picture is favorable as well.

On Tuesday, following the inflation news, the odds of a September rate cut jumped to 92% from 86% on Monday, according to futures market data compiled by the CME Group. They are up from just 57% a month ago.

Bond prices move in the opposite direction to interest rates, so lower rates should boost the value of investors’ bond funds. Of course, one big question is how much expectations for interest-rate cuts have already been factored into bonds’ prices.

Investors have already reaped at least some of the gains from potential rate cuts as anticipation has mounted over the past month. The iShares Core U.S. Aggregate Bond ETF returned 1.3% over the four weeks through Monday, according to FactSet.

Meanwhile, the iShares 20+ Year Treasury Bond ETF , focused on more rate-sensitive long-term bonds, returned 2.35%. While that may not sound like all that much, if the fund kept up that pace for a full year, its annual return would amount to nearly 30%.

With such gains already in the books, Tuesday’s good news on the inflation front may fall into the category of potential problem averted, rather than unforeseen boon for bondholders. The iShares Core Aggregate ETF was down 0.2% in early trading Tuesday. The iShares 20+ Year Treasury Bond ETF declined 0.9%.

ClearBridge Investments strategy analyst Josh Jamner theorized that traders may have been moving money into riskier assets such as stocks to “unwind hedges they had put in place to protect against the risk of an upside surprise in the data, which failed to materialize.” Stronger-than-expected inflation likely would have sent bond prices lower.

Regardless of Tuesday’s price moves, bond investors should consider themselves well-positioned heading into the fall. They are certainly in a better place than over the past several years, a time when bonds have frequently disappointed.

Bond yields look healthier than they have in years. On Tuesday, yields on 10-year Treasury notes climbed 0.03 percentage point to 4.30%, up from around 3.9% a year ago, and from just above 2% in March 2022, when the Fed started raising rates to fight surging inflation. Yields on those notes have rarely exceeded 4% since before the 2007-2008 financial crisis.

Comparatively high rates offer a double benefit for bond investors. They mean higher income in terms of interest payments. And higher short-term rates give the Fed extra flexibility to implement additional rate cuts, if inflation remains under control and economic growth slows.

In fact, Wall Street expects the Fed to follow up a September rate cut with three more in the next 12 months, according to the CME. That means bonds still have room to run, assuming inflation remains under control.

Write to Ian Salisbury at ian.salisbury@barrons.com