August Inflation Came in Hot, and the Odds of a September Rate Hike Are Now 85%. But There's a Silver Lining Driving Stocks Higher.

All eyes were on the August Consumer Price Index (CPI) released on the morning of Sept. 11, as it was the last major data point before the Federal Open Market Committee (FOMC) makes a decision on interest rates at its meeting on Sept. 15-16.

Unfortunately for the doves, the inflation data came in slightly hotter than expected.

The CPI rose 0.4% in August, seasonally adjusted, bringing the headline year-over-year number to 3.4%. Both of those numbers were in line with economists' estimates.

However, core CPI, which strips out more volatile food and energy prices, rose 0.3% in August, 0.1% higher than estimates. Headline core CPI rose 2.4%, in line with estimates.

Following the report, the odds of a quarter-point rate hike at the FOMC's upcoming meeting rose from about 72.4% yesterday to nearly 87%, as of 12:26 p.m. ET on Sept. 11, according to the CME Group's FedWatch tool.

Although rate hikes are perceived as negative for stocks, the Dow Jones Industrial Average has surged 527 points as of this writing. The other major indexes were also green.

Here's the silver lining driving stocks higher today.

Image source: Getty Images.

The FOMC had started to become more hawkish

Now, not long ago, I didn’t think the FOMC would hike interest rates this year.

There had been signs of easing inflation, and inflation would likely have subsided more if the Iran war had ended or at least tensions had eased between both sides. I also believed the FOMC and Fed Chair Kevin Warsh would want to avoid raising rates just weeks before the midterm elections.

However, the bond market has been a constant thorn in the Fed's side. The yield on the 10-year Treasury note is roughly 4.95%, as of this writing, while the yield on the 30-year Treasury bond is around 5.34%.

Not only do higher bond yields increase borrowing costs for consumers and businesses, but they also raise the cost of new debt issued by the U.S. government. That's not good, considering total U.S. debt has topped $40 trillion and interest payments already consume 15% of the federal budget.

US Core Consumer Price Index MoM data by YCharts

We've already seen U.S. Treasury Secretary Scott Bessent make multiple moves in recent weeks to try to rein in bond yields.

At the FOMC's last meeting, three of the 12 voting members on the committee dissented in favor of a quarter-point hike. Since then, more FOMC members have publicly said they would support a September rate hike if inflation does not show signs of slowing.

The bond market may welcome a Fed hike

Investors have been watching the bond market closely. Longer-term yields have already been moving higher, due to concerns about inflation and debt. But I also think that yields began to move when the FOMC didn't raise rates at its last meeting.

Bond investors have seemingly grown frustrated with the FOMC for saying that they plan to rein in inflation, but not taking any action to do so.

With investors now seeing a high likelihood of a rate hike at the Fed's September meeting, they may believe an actual hike will help lower inflation expectations and, in turn, long-term bond yields.

As of this writing, the yield on the 10-year Treasury note had risen marginally on the day, while the 30-year yield was slightly down.

Now, there's no guarantee the FOMC will move forward with a hike at the upcoming meeting; the Fed has been less forthcoming since Warsh took over. But the market largely expects it and also sees a roughly 48% likelihood of another quarter-point hike at the FOMC's final meeting of the year in December.

The major indexes have fallen in each of the four days prior to Sept. 11, so it's possible the rate hike was already priced in.

But with the 10-year yield recently exceeding 5%, I think the bond market was essentially screaming at the Fed to address inflation. With the majority of investors now projecting a hike, the bond market may feel more satisfied that the Fed will do its job, which is why yields have come in a little.

But only time will tell. The FOMC's September meeting is likely to be quite eventful.

Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends CME Group. The Motley Fool has a disclosure policy.