(Bloomberg) — The emerging consensus that the Federal Reserve will raise rates just one or two more times has ushered in a brand new set of dilemmas for bond investors, who now must resolve which parts of the market will fare best under the circumstances.

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The US Treasury market reached an inflection point Thursday when a report showed that consumer inflation rates declined to the bottom levels in greater than a yr, and Philadelphia Fed President Patrick Harker quarter-hour later said he favored one other downshift within the pace of rate increases. Market-implied expectations for the central bank’s February meeting gravitated further toward a quarter-point hike as an alternative of a half-point, and for the primary time gave small odds to the opportunity of no move in any respect in March.

Short- and intermediate-term yields declined sharply, reaching the bottom levels in three months, while the 10-year slid below 3.5%, extending a rally from about 3.8% initially of the yr. Loads of uncertainty stays; earlier this week, two other Fed officials predicted an prolonged stay above 5% for the Fed’s overnight benchmark. But investors are finally looking past the specter of higher policy rates as they set positions.

“The market has discounted all of the Fed’s language about pushing the terminal rate higher than 5%,” said Ed Al-Hussainy, a rates strategist at Columbia Threadneedle Investments. Having favored long-dated bonds in recent months, he anticipates intermediate sectors will fare best on the approach to the top of the climbing cycle. Eventually, “once the Fed tells us that is the last hike — and March is an honest bet around that — then the front end is there for the taking.”

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Bond investors were decimated last yr by rising yields because the Fed raised its goal range for overnight rates of interest by greater than 4 percentage points in response to quickening inflation.

Accumulating evidence that inflation has peaked allowed the Fed to ease up on the brakes in December with a half-point increase following 4 straight three-quarter-point moves. The most recent slowdown in the expansion rate of consumer prices in December — excluding food and energy, the fourth-quarter rate was 3.14%, a 15-month low — unleashed a wave of trading.

In swap contracts referencing Fed meeting dates, the expected peak for the overnight rate declined toward 4.9%. Just 29 basis points of increase are priced in for the Feb. 1 decision — indicating a quarter-point is favored over a half-point — and fewer than 50 basis points are priced in by March.

A blizzard of wagers in short-term interest-rate options after the inflation data anticipated the upcoming end of Fed rate hikes and extra declines in market volatility. They included a big one expressing the view that the cycle will pause after February.

“The trail of short-term rates is tied to inflation, with a swing factor around that attributable to how strong or weak the economy is looking,” said Jason Pride, chief investment officer of Private Wealth at Glenmede. “A 5% funds rate is mandatory if inflation is running at 6% and seven%, not so when inflation is back all the way down to 3%, and you can see year-over-year headline inflation around 3% by the center of the yr.”

Beyond the short-term rate market, the brand new framework spurred wagers on additional Treasury market gains.

In Treasury futures, Thursday’s rally resulted in big increases in open interest — the numbers of contracts by which there are positions — particularly for 10- and 5-year note contracts. The rise was such as the acquisition of $23 billion of probably the most recently issued 10-year note, about 20% of the quantity outstanding.

The ten-year Treasury yield, which peaked last yr near 4.34%, has scope to retreat to around 2.5% inside six months if the inflation trend is sustained, Al-Hussainy said.

“A lot of the risk premium within the long end of the curve reflects inflation and if it comes down faster, and even at the present pace, there’s an enormous runway for the long end to reprice,” he said.

It might be too soon. A period of consolidation could also be in store for the Treasury market after its steep gains.

“The inflation story shouldn’t be over yet, and there’s some market complacency that they’ve the suitable Fed playbook,” said Lindsay Rosner, multisector portfolio manager at PGIM Fixed Income.

Treasury yields were led higher last yr by short maturities just like the two-year, which stays the highest-yielding a part of the market at around 4.21%. PGIM expects a reversal of that trend, but it surely may take a while to get going.

“The steepener is the suitable trade for this yr, and it really starts once the Fed ends climbing,” she said.

What to Watch

Economic calendar:

• Jan. 17: Empire manufacturing

• Jan. 18: Retail sales; producer price index; industrial production; business inventories; NAHB housing market index; mortgage applications; Fed Beige Book; Treasury International Capital Flows

• Jan. 19: Housing starts; Philadelphia Fed Business Outlook; jobless claims

• Jan. 20: Existing home sales

• Fed calendar:

  • Jan. 17: Recent York Fed President John Williams

  • Jan. 18: Atlanta Fed President Raphael Bostic; Philadelphia Fed President Patrick Harker; Dallas Fed President Lorie Logan

  • Jan. 19: Boston Fed President Susan Collins; Vice Chair Lael Brainard; Williams

  • Jan. 20: Harker; Governor Christopher Waller

• Auction calendar:

  • Jan. 17: 13-week, 26-week bills

  • Jan. 18: 17-week bills; 20-year bonds

  • Jan. 19: 4-week, 8-week bills; 10-year Treasury inflation-protected securities

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