Wall Street sounds the alarm! Inflation retaliation is brewing, and market complacency may be backfiring.

The interest rate trading department of Citigroup said that the market is overly optimistic about the US inflation outlook, making trades that bet on rising price pressures attractive. Benjamin Weltchill, a strategist at Citibank's interest rate trading desk, stated that investors may be underestimating the resilience of US consumers, and the market's expectations for inflation may be slightly revised upwards. He said, "The market seems to be convinced that inflation will fall, but we are still in a structurally higher inflation environment." He recommended investors buy "five-year forward inflation swaps". Currently, the Fed's preferred core inflation indicator stubbornly remains just below 3%. Citigroup's comments follow strong US jobs data released on Wednesday. The data caught investors off guard and pushed US bond yields up, as traders lowered expectations for a Fed rate cut this year. On Thursday, US bond yields stabilized, with the 10-year yield falling 1 basis point to 4.17%. Traders will closely watch the US Consumer Price Index (CPI) data for January, set to be released on Friday. Weltchill noted that since last year, US tariff policies have not quickly translated into higher inflation levels, leading many investors to be disappointed, and the market is hesitant to factor in more inflation risks. He said, "The market lacks the drive to reassess the inflation premium. Structurally, inflation risks are underestimated." It's worth noting that fund managers from BlackRock, Bridgewater Associates, and Pimco are also positioning themselves defensively for a new wave of inflation. A fund under BlackRock is building short positions on US and UK government bonds, in case the expected rate cut is not achieved. Bridgewater prefers stocks over bonds. Pimco is optimistic about the hedge provided by US Treasury Inflation-Protected Securities (TIPS) with inflation adjustments. More and more signs indicate that their concerns are not unfounded. In January, the yield spread between US Treasuries and inflation-protected bonds surged to multi-month highs. Inflation swaps, another market expectation indicator, also rose in tandem. The view that inflation may make a comeback is based on expectations of a strong US economy pushing prices higher, especially if Kevin Warsh, the next nominee for Fed chairman by the US president, pushes for faster or larger rate cuts. Looking broadly, rising commodity prices, government debt issuance, and increased spending on artificial intelligence also exacerbate inflationary pressures. Ben Pearson, senior trader at UBS Group, stated that the "inflationary boom" led by the US is the biggest risk underestimated by investors this year. Pearson said that if this scenario becomes reality, it would compel the Fed to "stand completely still" in the first half of the year and force the market to reassess its expectations for interest rate hikes in the second half. Steven Barrow, head of G-10 strategy at Standard Chartered Bank, predicted that if the White House's desire for rate cuts is frustrated, the 10-year US bond yield could jump from the current level of about 4.25% to 5%. This means Warsh will face a challenging start. If confirmed by the Senate, he will succeed Chairman Powell at the Fed in May when his term ends. Investors need to weigh Warsh's long-standing reputation as an "inflation hawk" against whether he is willing to implement the rate cuts sought by Trump. Two newly appointed Fed officials with voting rights this year stated on Tuesday that they currently lean towards keeping rates unchanged due to concerns about the inflation outlook, while continuing to observe economic and price trends. Cleveland Fed President Mester pointed out that inflation levels remain elevated and have been essentially flat over the past two years. She believes that the risk of inflation remaining close to 3% this year still exists, which has been a major characteristic of the past two years. She emphasized that it is difficult to support further easing policy without clear evidence of a significant and sustained decline in prices. Instead of "tinkering" with rates, she prefers to "choose patience, slow down a bit" in evaluating the effects of the three rate cuts last fall and the performance of economic growth. Mester stated that she believes the current monetary policy is in a "comfortable position" to temporarily stand still, evaluate future data, and determine whether policy needs further adjustment, according to her forecasts, the Fed may maintain rates unchanged for a considerable time. Another Fed voter this year, Dallas Fed President Kaplan, also said that her concerns about "stubbornly high" inflation are rising. She believes that the three rate cuts implemented by the central bank last year to prevent deterioration in the labor market have objectively increased the risk of an inflation rebound. She said she is currently more concerned about inflation remaining high than about the economy overheating. Kaplan pointed out that the data in the coming months will test whether inflation is truly moving toward the Fed's 2% target, and whether the labor market can remain stable. If inflation does drop and the labor market remains resilient, this will indicate that the current policy stance is appropriate and further rate cuts are unnecessary to achieve the Fed's dual mandate. She added, if inflation does drop but the labor market cools further, then another rate cut "may become appropriate". Although Kaplan expects that, this year, as the impact of tariffs that previously pushed commodity prices higher gradually fades, inflation will make some progress, she admitted that she was not fully convinced that inflation would smoothly return to the 2% target. She cited anecdotal evidence from Fed surveys that tariffs still need to continue to be transmitted to end prices this year. At the same time, she noted that there is no clear sign of further cooling in core non-housing services inflation, which has remained flat overall since 2025.