Bond traders cut Fed rate hike bets as 10-year Treasury yield falls below 5%

Bond traders are backing away from bets that the Federal Reserve will raise rates again, even as oil trades around $112 a barrel. The 10-year Treasury yield (^TNX) slipped back below 5% on Thursday and was on track for its biggest one-day drop in more than two years.

The move came as Treasurys rallied and stocks slid. When bond prices rise, yields fall. Mortgage rates tend to follow the 10-year Treasury yield, so the shift matters for homebuyers.

Fed odds fall sharply

The Fed meets next week, on Oct. 28. Investors had been bracing for a rate increase to fight perceived oil-driven inflation. Fed funds futures now put the odds of an October hike at about 5%, according to Bloomberg data. That is down from 15% on Wednesday and 37% at the end of September.

The December outlook has also shifted. As recently as Wednesday, traders were fully priced for a hike by year-end. Now they see roughly a 75% chance.

Oil spike, but inflation expectations steady

Brent crude (BZ=F) is trading around $112 a barrel, more than 50% higher than before the Iran war began in late February. Normally, that kind of spike would have bond investors worried about inflation and pushing interest rates higher.

Even with oil soaring, the bond market's inflation forecast has barely budged. The gap between regular Treasurys and Treasury Inflation-Protected Securities, or TIPS, says investors expect inflation to average about 2.4% a year over the next five years. That is the same as before the war started.

Most of the rise in yields this year came from real yields, which is what bonds pay after inflation. That is a bet the Fed will keep rates high enough to stop oil from turning into lasting inflation, not a bet that inflation is about to take off.

Not everyone buys the market's calm. Bloomberg strategist Simon White argues breakevens are "mispricing" the oil shock.

Mortgage rates and housing

The average 30-year fixed mortgage rate fell to 7.32% this week from 7.40%, according to Freddie Mac. That was the first drop in two months, after a seven-week climb that took rates to their highest level since 2023. Before the war, rates were just under 6%.

Freddie Mac's survey does not capture Thursday's bond rally. If yields stay lower, mortgage rates could follow in the coming days.

The damage from this fall's surge is already showing. Pending home sales, which track signed contracts, fell to a record low in September, according to the National Association of Realtors. "Market conditions weakened in September due to fast-rising mortgage rates," said NAR chief economist Lawrence Yun.

About 14.5% of homes fell out of contract in September, according to Redfin data. That is the highest share on record outside the early months of the pandemic.

What to watch

The bond rally held up through Thursday afternoon's sale of five-year TIPS. Bloomberg strategist Cameron Crise saw a sign that some big investors were scrambling to unwind bets on higher rates. The next big test is the Fed decision next Wednesday.