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US inflation worries have cooled significantly over the past few weeks. Inflation swaps are pricing in July’s CPI at 2.9% YoY (consensus: 3.0%), followed by another dip to 2.6% in August. 10Y breakevens have also dropped significantly and are now trading at 2.1%, from around 2.30% in mid-July. Part of this drop in inflation expectations is driven by relatively benign inflation prints over the past three months that eased worries that the spike in 1Q CPI would be sustained. The other part can largely be attributed to sentiment. When the stock market corrected two weeks ago, real yields fell alongside breakevens. However, despite the recovery in sentiment over the past week, the USD rates (nominal yields, real yields and breakevens) did not quite buy into the optimism and stayed low.
There is a need to differentiate between cyclical and structural factors when considering the outlook for US inflation and hence rates. Cyclically, inflation is much less of a worry. It is optically a lot more palatable for the Fed to cut when headline CPI is below 3% (an event that is likely within the coming two CPI prints). Further out, we think structural factors should play a greater role in keeping inflation elevated compared to what was seen in the post-GFC environment. Deglobalization worries and more frequent supply-side shocks should lead market participants to factor in an inflation premium. We think 10Y breakevens may be too optimistic about the long-term inflation path.
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