May’s University of Michigan Consumer Sentiment report is due today. Many expect inflation expectations to drop due to recent trade news. However, an increase in these expectations would be surprising. The Federal Reserve is particularly concerned about inflation expectations and might hold off on rate cuts if economic growth picks up soon. A rate cut too early could raise inflation expectations and long-term Treasury yields, which some may not anticipate.

The Federal Reserve Target Challenge

The Federal Reserve struggles to meet its target amidst hopeful growth forecasts, potential boosts in economic activity, tax cuts, deregulation, and existing 10% tariffs. If inflation expectations rise, it could lead to changes in interest rate expectations across different asset classes. A hawkish approach may result in a preference for the USD and a decline in long-term Treasury bonds. The stock market might also see reductions, as current investments seem overstretched. These points illustrate that inflation expectations in the U.S. are under close watch, especially with the upcoming University of Michigan data. If consumers expect prices to rise more quickly, they might lose confidence in the Federal Reserve’s ability to control inflation. Central banks often struggle to manage actual inflation if expectations drift away from target levels. So far, some market participants expected price pressures to ease, likely due to recent trade policy changes. However, this belief may not hold if today’s data surprises with higher numbers.

Cautious Stance on Interest Rate Cuts

The central bank is being careful not to misinterpret temporary trends and may delay interest rate cuts until there’s more confidence in disinflation. Lowering rates too soon—especially if the economy shows improvement—could backfire and rekindle inflation, particularly as fiscal policies remain somewhat expansionary. Increased economic activity may also pressure wage growth and consumer prices. In this situation, any rise in inflation expectations could quickly push interest rate expectations higher. Longer-dated bond yields may rise, as investors will demand higher returns under uncertain inflation conditions. A decline in demand for 10- and 30-year Treasuries seems likely if real yields rise. This could reduce interest in riskier assets. Powell and his team are walking a fine line. Current positioning across various asset classes suggests that a lot of the existing optimism is based on overly positive scenarios. Overextended long positions in equity and fixed-income could be vulnerable if market data challenges the disinflation narrative. For now, we must pay close attention to the bond-equity relationship. If growth rebounds and the Fed changes its approach, spurring inflation to rise, this could lead to a repricing of assets. We should avoid assuming a quick policy reversal. Instead, it may be wise to prepare for a longer period of higher conditions. Dollar investments are becoming more attractive, especially with nominal differentials appearing less negative. There’s little reason to anticipate a smooth path for rates-sensitive currencies if CPI and labor data remain stubborn. Treasury futures could stay under pressure if real rates become a focus again. With sentiment strongly leaning toward the idea that the Fed’s next move is a cut, any contrary data could be disruptive. Current positioning suggests a soft landing with little policy tightening, which doesn’t fully account for the upward risk to rates or the resilience of consumer behavior. Equity valuations have increased while discounting fewer risks in earnings, so any movement in yields might create volatility. From a derivatives standpoint, implied volatility curves may seem cheap in this environment. The skew towards downside put hedges could steepen if realized volatility rises due to repricing concerns. Short-term gamma exposure may provide better entry points than locking in long-duration positions that are prone to mispricing. Thus, it’s best to stay agile and evaluate cross-asset dynamics on a weekly basis. Sentiment changes often begin in rates and affect other areas. Create your live VT Markets account and start trading now.

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