Friday’s highly anticipated inflation report made it harder for the Federal Reserve (Fed) to justify holding interest rates steady. The odds of a rate hike at next week’s meeting have risen from roughly a coin toss a month ago to nearly 90% today. Core inflation, which excludes food and energy, rose more than expected in August, with shelter and other service-related costs remaining firm. This was not an inflation breakout. Core inflation is up 2.4% over the past year. The problem is that the report offered little evidence that underlying inflation pressures are fading enough to bring inflation sustainably back to the Fed’s 2% target.

The economy is also showing few signs of the weakness that would typically warrant a more patient approach. Employment remains solid, while economic growth and spending remain strong. This gives the Fed more room to focus on inflation. Oil prices add another layer of uncertainty. While gasoline affects headline rather than core inflation, sustained higher oil prices can raise transportation and production costs, which could eventually filter through to a wider range of goods and services. With no clear resolution to the conflict with Iran, that pressure could persist.

A Fed hike may ultimately be less threatening to longer-term yields than another decision to hold. Friday’s market reaction points in that direction. As the probability of a September hike increased, the 10-year Treasury yield fell and stocks rallied. This reaction is consistent with markets being comfortable with a modest rate increase.

The reason for this is that long-term bond yields reflect more than the Fed’s overnight rate. They also incorporate expectations for future inflation and the risk that policymakers could fall behind. Long-term yields have already moved higher this year as strong growth and persistent inflation raised concerns that monetary policy may not be restrictive enough. A hike next week could reinforce confidence that the Fed remains committed to bringing inflation down. Another hold could have the opposite effect if investors conclude the Fed is allowing inflation to remain too high, potentially keeping long-term yields elevated even without an increase in the policy rate.

Canadian policy divergence but connected markets

Canada and the United States (US) appear to be heading in different directions on monetary policy. While the Fed is increasingly expected to raise rates, the Bank of Canada (BoC) has more room to remain on hold. The Canadian economy delivered strong growth in the second quarter, but escalating trade tensions with the US are expected to weigh on growth in the second half of the year. At the same time, underlying inflation in Canada is close to 2%, giving policymakers less reason to tighten policy.

While the BoC may be able to hold its policy rate steady, Canadian households and businesses could still face higher borrowing costs. Longer-term Canadian bond yields are heavily influenced by the US bond market, meaning Canada is not insulated from rising global yields. As US yields have risen this year on stronger growth, persistent inflation and increased demand for capital, Canadian yields have followed suit. That matters because longer-term yields feed directly into Canadian mortgage rates and other borrowing costs, even if the BoC does not raise its overnight rate.

Bottom line

All eyes are on the Fed’s September 16 meeting. While the likelihood of a rate increase has risen sharply, there is still uncertainty around next week’s decision. However, a rate hike at some point this year now looks very likely, a significant shift from earlier this year, when markets were anticipating rate cuts. More importantly, longer-term bond yields are moving independently of central bank policy rates, affecting borrowing costs, fixed income returns and equity valuations. Equity markets have remained strong because earnings growth has been exceptional. However, with interest rates becoming a greater headwind, we are watching the degree to which that earnings momentum and strong investor sentiment can be sustained into next year.