Trump Victory Spurs TIPS Surge, Market Underestimates Inflation Risks
In the wake of Donald Trump's election victory, Treasury Inflation-Protected Securities (TIPS) have surged, with breakeven rates rising more than 10 basis points. However, market prices have yet to fully account for the inflation risks amplified by the election's outcome.
While Trump's win wasn't necessary to push inflation higher in the U.S., his policies could certainly accelerate it. Inflationary pressures were already mounting due to strong economic growth, solid corporate profit margins, China's significant economic stimulus, and the nearly $2 trillion fiscal deficit in the U.S. If Trump follows through with his expected policies—tariffs, tax cuts, and increased government spending—these price-growth risks could escalate even further.
Yet, the market seems to be underestimating inflation's upward trajectory. Currently, only about 40% of the movement in yields can be attributed to breakevens, a measure of inflation expectations. Meanwhile, CPI fixing swaps, which represent the market's outlook on Consumer Price Index (CPI) inflation over the next 12 months, have shown minimal movement. Though these swaps are less liquid and could fluctuate throughout the day, they reflect a similar view when compared to SOFR options.
The market's implied probability of a severe inflation scenario, one that would compel the Federal Reserve to raise interest rates to 4.75% by December 2025, remains low. This scenario assumes the Fed will reduce rates by 25 basis points at the upcoming meeting as anticipated and then hike them again next year. Although this probability has inched upward, it still hovers at a little over 10%.
As of now, it may seem improbable that the Federal Reserve would need to increase rates again in the near term. However, with such a broad range of possible outcomes and inflation already proving sticky, that 10% risk may be undervalued. The persistently high inflation could push the Fed into a position where further rate hikes become necessary sooner than expected.
