Analysts Anticipate Key Inflation Data Impact
Morgan Stanley interest rate strategists caution that unexpectedly soft inflation data and falling oil prices this week could push down bond market expectations for inflation over the next two years. The firm’s team, led by Aryaman Singh, advises clients in the inflation swap market to prepare for a potential narrowing of the inflation premium between short- and long-term expectations.
Short-Term Inflation Premium at Unusual Levels
The two-year inflation rate (currently around 2.79%) has traded above the 10-year rate (approximately 2.48%) since election day—a reversal of the typical relationship between these tenors. Market participants now anticipate this inversion may soon reverse course.
Critical CPI Report Looms Large
Wednesday’s release of May consumer price index (CPI) data takes on heightened significance, as it will provide crucial insights into how tariffs are initially affecting core goods prices. Bloomberg economists’ median forecasts show headline CPI expected to rise 0.2% month-over-month, with core CPI (excluding food and energy) projected to increase 0.3%.
However, inflation swap markets currently price in more modest gains of 0.12% and 0.23% respectively. “This instrument has proven more accurate in forecasting CPI outcomes,” the strategists note.
Market Signals Diminishing Tariff Impact
Additional evidence suggests market participants are scaling back expectations for future tariff effects. One-year inflation swap rates have been declining steadily, indicating reduced anticipation of higher effective tariff rates.
Potential Strategy Outcomes
While the current 31-basis-point spread between two-year and 10-year CPI swap rates may compress to just 10 basis points, the strategists recommend a stop-loss at 45 basis points if the gap widens. Key risks to this view include unexpected upward pressure on core goods CPI or potential increases in effective tariff rates.
Supporting Factors for the Trade
Several elements bolster the case for this positioning:
- Global equity markets and financial conditions currently favor rising 10-year inflation expectations
- Commodity strategists at Morgan Stanley forecast oil price declines that will likely weigh more heavily on short-term inflation than longer-term measures
The firm emphasizes these dynamics create a compelling case for the proposed trade, though participants should remain vigilant about potential upside surprises in the inflation data.
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