Market Tightens Before Fed, Interest Rate Hike Probability Falls

The US Federal Reserve has been given more time to consider its next move on interest rates after July's inflation figures showed a slight decline, but the market has already tightened financial conditions through rising bond yields.

The consumer price index fell to 3.4% year-over-year in July, with core inflation at 2.5%, excluding volatile components such as food and energy prices. This leaves the door open for a possible interest rate rise by the Federal Reserve at its next scheduled meeting in September.

The implied probability of a further rate rise has fallen to 40% from 50% following the release of the consumer price index, according to the CME's FedWatch. However, the market has already done some of the 'dirty work' on the Fed's behalf through a rise in bond yields, particularly for longer maturities.

The nominal yield on the 10-year US government bond has been hovering around 4.65% for the past few days, with real interest rates reaching 2.4%, their highest level in over two years. This sharp rise in borrowing costs has effectively translated into a direct increase in borrowing costs for businesses and households.