Market participants have largely written off inflation, but dynamics are shifting again. Last week’s set of labour market data suggests that the US economy is resilient. Moreover, with the unemployment rate heading a different direction from the Fed’s SEP, the Fed’s easing path to 3% (as laid out in the dotplot) is now being questioned. Against this backdrop, there are two scenarios to consider. First, Goldilocks, where the economy holds up but inflation stays benign. Second, no-landing, where CPI starts to tick up again as the economy stays strong. Throw in rising oil prices and Chinese stimulus, and the trajectory for USD rates look biased higher. To be sure, oil prices have been a tailwind for declining inflation and this should still be the case for October. However, the global outlook is shifting, triggering an adjustment in USD rates in the process.
2Y breakevens have risen to 2.00%, from a nadir of 1.47% in early September. 10Y breakevens have also risen, but at a more muted 22bps. As things stand, we think that breakevens are now more appropriately priced. Consensus expects muted prints (0.1% MoM for CPI and 0.2% MoM for core CPI) this week. We think that the reaction to an inflation beat may be asymmetric even as nominal yield levels are more reasonable now. Optically, the YoY print may well be below 2.5% and ostensibly lead to a kneejerk decline in yields. However, we think that the outlook (upside risks to inflation due to oil prices and upside to the global economy) is more important. Notably, low CPI prints would not be sufficient to prompt a more aggressive Fed. Conversely, CPI upside surprises would raise questions on the pace of easing and the terminal FFR.
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