May’s University of Michigan Consumer Sentiment report is expected today. While many anticipate a decrease in inflation expectations due to recent trade developments, further increases in these expectations would be unexpected.

The Federal Reserve is especially focused on inflation expectations and may exercise caution regarding rate cuts if growth picks up soon. A premature rate cut might lead to increased inflation expectations and rising long-term Treasury yields, contrary to some beliefs.

The Federal Reserve Target Challenge

The Federal Reserve faces the challenge of not having reached its target amid optimistic growth forecasts, potential economic activity surges, tax cuts, deregulation, and existing 10% tariffs. If inflation expectations rise, it may prompt a reevaluation of interest rate expectations across various asset classes.

A hawkish shift may lead to a preference for USD and a decrease in long-term Treasuries. There could also be a reduction in the stock market as current positioning appears overstretched.

These paragraphs highlight how inflation expectations in the United States are being closely watched, especially in relation to the upcoming University of Michigan data. If consumers believe prices will rise more quickly than before, it could mean that people are less confident in the Federal Reserve keeping inflation under control. Central banks often find it harder to manage actual inflation if expectations begin to shift away from target levels. So far, some market participants had anticipated price pressure to soften, likely influenced by recent trade policy revisions, but that assumption may not hold if today’s figures surprise to the upside.

Cautious Stance on Interest Rate Cuts

The central bank, wary of interpreting temporary trends too hastily, is taking a cautious stance—possibly delaying interest rate cuts until higher confidence in disinflation returns. Lowering rates too early, particularly in an environment where the economy starts showing stronger performance, could backfire. It risks fuelling inflation again, especially when fiscal policy is still moderately expansionary. More economic activity puts further pressure on wage growth and consumer prices. Against that backdrop, any uptick in inflation expectations may quickly force expectations around interest rates to shift upward.

Yields on longer-dated bonds could rise as a result, since investors would need higher compensation to lend under less predictable inflation conditions. A pullback in demand for 10- and 30-year Treasuries seems probable if real yields reset higher. That, in turn, might dampen appetite for riskier assets.

Powell and his team appear to be walking a fine line. Positioning across most asset classes suggests that much of the current optimism prices in only benign outcomes—perhaps too optimistically. Overextended long equity and fixed-income positions appear vulnerable if market data starts pushing against the disinflationary narrative.

In the short-term, it seems clear that we need to consider the bond-equity correlation carefully. If a rebound in growth leads the Fed to adjust course, and inflation readings climb higher with it, this may initiate a repricing scenario. From our point of view, it’s better to avoid assumptions of a quick policy reversal. Rather than planning for imminent rate relief, it may be wise to prepare for pricing to reflect higher-for-longer conditions.

Dollar exposure shows signs of becoming more attractive in this setup, particularly with nominal differentials looking less negative. Tactically, there’s little reason to expect a smooth ride in rates-sensitive pairs if incoming CPI and labour figures remain sticky. Treasury futures could stay under pressure should real rates shift back into focus.

With sentiment leaning heavily on the idea that the Fed’s next step involves cutting, any data that challenges this belief would be disruptive. We’ve seen positioning that depends on a soft-landing scenario with little policy tightening—this doesn’t fully reflect the upward risk to rates or the resilience in underlying consumer activity. Equity valuations have run higher while discounting fewer earnings risks, and any move in yields could stir volatility.

From a derivatives perspective, implied volatility curves may look cheap under these conditions. Skew towards downside put hedges might steepen if realised volatility picks up on repricing concern. In this context, shorter-term gamma exposure may offer better entries than committing to duration-heavy views susceptible to mispricing.

It remains best, then, to stay nimble and carefully assess cross-asset dynamics week by week. Sentiment shifts tend to start in rates and ripple outward.

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