Citigroup's rates trading desk has indicated that markets are excessively complacent regarding the US inflation outlook, making trades betting on rising price pressures attractive. Benjamin Wiltshire, a strategist on the desk, suggested that investors may be underestimating the resilience of the US consumer, and market inflation expectations are likely to be revised slightly higher. He stated, "The market seems convinced that inflation will fall, but we remain in a structurally higher inflation environment." He recommended investors consider purchasing "five-year forward inflation swaps." Currently, the Federal Reserve's preferred core inflation measure remains stubbornly just below 3%. These comments from Citigroup follow strong US employment data released on Wednesday, which caught investors off guard and spurred a sharp rise in US Treasury yields as traders scaled back expectations for Fed rate cuts this year. On Thursday, US Treasuries stabilized, with the 10-year yield dipping 1 basis point to 4.17%. Traders will next focus closely on the US Consumer Price Index (CPI) data for January, due Friday. Wiltshire noted that, given the disappointment many investors felt last year when US tariff policies did not quickly translate into higher inflation, the market is reluctant to price in more inflation risk again. He said, "The market lacks the impetus to reprice inflation risk premium. Structurally, inflation risks are underpriced." Notably, fund managers at BlackRock, Bridgewater Associates, and Pimco are also positioning defensively for a potential new wave of inflation. A BlackRock fund is building short positions in US and UK government bonds as a hedge against anticipated rate cuts failing to materialize. Bridgewater currently favors equities over bonds. Pimco sees value in the buffer provided by US Treasury Inflation-Protected Securities (TIPS). Increasing signs suggest their concerns are not unfounded. In January, the yield gap between US Treasuries and TIPS widened significantly, reaching multi-month highs. Inflation swaps, another market expectation gauge, also moved higher. The view that inflation could resurge is based on expectations that robust US economic strength will push prices up again, especially if Kevin Warsh, the US President's nominee for the next Fed Chair, advocates for faster or deeper rate cuts. More broadly, rising commodity prices, significant government borrowing, and a surge in AI-related spending are also adding to inflationary pressures. Ben Pearson, a senior trader at UBS Group, stated that a US-led "inflationary boom" is the most significant risk underestimated by investors this year. Pearson suggested that if this scenario materializes, it could leave the Fed "completely on hold" in the first half of the year and force markets to price in rate hike expectations during the second half. Steven Barrow, head of G-10 strategy at Standard Chartered, predicted that if the White House's desire for rate cuts is thwarted, the 10-year Treasury yield could jump to 5% from the current level of around 4.25%. This would present a challenging start for Warsh. If confirmed by the Senate, he would assume the role of Fed Chair after Chairman Powell's term ends in May. Investors will need to weigh Warsh's long-standing reputation as an "inflation hawk" against his willingness to implement the rate cuts sought by the President. Separately, two new voting members on the Fed's policy committee this year expressed a preference this week for holding rates steady due to inflation concerns. Cleveland Fed President Hammack pointed out that inflation remains elevated and has largely moved sideways for over two years. She sees a risk that inflation stays near 3% this year, mirroring the pattern of the past two years. She emphasized that, without clear and sustained evidence of declining prices, it would be difficult to support further easing. Preferring patience over fine-tuning rates, she advocated for assessing the effects of last autumn's three rate cuts and economic growth. Hammack stated she believes current monetary policy is in a "good place," allowing for a pause to evaluate incoming data and judge if and how policy might need further adjustment. Based on her forecasts, she suggested the Fed could keep rates unchanged for a considerable time. Dallas Fed President Logan, the other new voter this year, also said her concern about inflation remaining "stubbornly high" is increasing. Logan believes the three cuts implemented last year to prevent labor market deterioration objectively increased the risk of an inflation rebound. She expressed greater current concern about inflation failing to subside than about an overheating economy. Logan noted that data in the coming months will test whether inflation is moving sustainably back toward the Fed's 2% target and if the labor market remains stable. If inflation does decline while the job market stays resilient, it would suggest the current policy stance is appropriate, requiring no further cuts to meet the Fed's dual mandate. She added that if inflation falls alongside further labor market cooling, then another rate cut "could become appropriate." Although Logan expects some progress on inflation this year as the effects of tariffs that boosted goods prices fade, she admitted she is not yet fully confident that inflation will smoothly return to the 2% target. Citing anecdotal evidence from Fed surveys, she noted that tariffs still need to pass through to final prices this year. Furthermore, she said she has not yet seen clear signs of further cooling in core non-housing services inflation, a category that has generally moved sideways overall in 2025.
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