U.S. Inflation: Heading Down, But Far from Out – February 21, 2023

A just-published report updated our view on the outlook for U.S. inflation, and concluded that recent CPI data is already signaling that there will be more persistence to inflation than the Fed and bond investors are currently discounting.

The point about being unprepared for the persistence of more elevated inflation than in recent decades is highlighted in the complacency evident in the CPI swaps market. After flaring in 2021-2022, when inflation rose to 40-year highs, U.S. CPI swap rates out to 30 years have now eased back to levels not much above where they were last decade when the secular stagnation and low-inflation-forever narratives dominated global financial market pricing.

Despite being blind-sided in 2021-2022, bond investors are discounting that the Fed will consistently hit its inflation target over the next 30 years, or at least they are not taking out insurance against a different outcome (i.e. do not require any extra compensation for the possibility of higher inflation or greater inflation variability down the road).

Net: we remain cyclically bearish on bonds, and note that the recent strength at the short end of the U.S. and euro area yield curves is a clear warning of further trouble ahead for longer-term bond yields.


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