Guotai Junan International: How to understand the "disconnect" in US inflation expectations?

Abstract After Trump was elected, concerns about "re-inflation" in the United States have intensified. Although Trump has not yet announced specific policy plans, market expectations for policies such as tax cuts have caused US bond yields to rise rapidly. For example, the benchmark 10-year Treasury yield rose by about 15 basis points in the week following Trump's victory and began to approach the 4.5% mark. In fact, this round of interest rate rebound has been occurring since the FOMC meeting in September, rising from around 3.6% to near 4.5%, a significant increase. The market's concerns may not only be about Trump's potential expansionary policies but also mixed with worries about upward pressure on medium-term inflation. Trump's election has only brought these concerns to the forefront or made them more explicit. We believe that inflation has an inherent tendency, which is in line with our description of the "Three Highs" new normal in the US economy - high inflation, high interest rates, and medium-high growth. The most important factor influencing the trend of medium-term inflation is inflation expectations. We tend to use the University of Michigan's 5-10 year inflation expectations as an anchor for predicting medium-term inflation. Comparing 1-year and 5-10 year inflation expectations, the divergence between them is becoming more pronounced, indicating that ordinary people believe inflation will continue to be a long-term problem. The conflict between short-term inflation changes and medium-term inflation expectations will bring several important issues. Firstly, the Fed will still choose to cut interest rates, but the terminal rate will likely be "restrictive," meaning that it needs to maintain a real positive interest rate to suppress inflation. Secondly, the 10-year Treasury yield will be in a relatively volatile state. Thirdly, after starting to cut interest rates, the market will pay more attention to related "uncertainties," causing the effectiveness of rate cuts to be questioned and leading to fragmented cuts - that is, each rate cut cannot simply lead to the next monetary policy action. However, the market is not without certainty. For example, after the rate cut in December, the US dollar's benchmark interest rate will fall to the level between 4.25-4.5%, with the median at 4.375%. Bonds above this interest rate level will have a positive carry. Investors can imagine various possible medium-term scenarios, but the importance of carry for fixed income investments is self-evident.The market will be in a relatively fluctuating state, reflecting the occasional concerns about inflation getting out of control (just like now). Third, after starting to reduce interest rates, the market will pay even more attention to the related "uncertainties", which leads to questioning the effectiveness of interest rate cuts, thus resulting in "fragmentation" of interest rate cuts - that is, each interest rate cut cannot simply be deduced to the next monetary policy move.But the market is not without certainty. For example, after the rate cut in December, the benchmark interest rate of the US dollar will decrease to the level of 4.25-4.5%, with a median of 4.375%. Therefore, bonds above this interest rate level will have positive carry. While investors can speculate on various possible mid-term scenarios, the importance of not losing carry in fixed income investment is self-evident. Finally, let us focus on the US inflation data for October, which will be released tonight. The market is expected to speculate on various possible outcomes, but based on the 1-year inflation expectations level already published by the University of Michigan, the probability of core inflation exceeding expectations in October seems to be small. Instead, we should ask ourselves, is Trump the devil in our hearts, or is it ourselves? This article is from the WeChat public account "Guojun Overseas Macroeconomic Research"; GMTEight Editor: Chen Xiaoyi.