Recent data has fueled concerns that inflation is becoming entrenched. However, the market’s pricing of future inflation is sending a different message. A 1-year inflation swap is a derivative contract that allows investors to exchange a fixed inflation rate for actual inflation over the next twelve months, making it a useful real-time measure of inflation expectations. The 1-year inflation swap is currently implying inflation closer to 2.5% over the next year despite recent CPI readings above 3%. If inflation drifts lower toward the levels implied by markets, it would reduce the urgency for additional monetary tightening. The Federal Reserve does not necessarily need to hike rates, let alone pursue an aggressive tightening campaign and can afford patience if inflation continues to move gradually closer to its objective.

Inflation measures the rate of change in prices, not the level of prices themselves. Consequently, inflation can move lower even if prices remain elevated. It simply means that prices are rising more slowly than they were a year ago. The coming year will compare against a period of already elevated price increases. As those stronger readings roll off, year-over-year inflation can moderate even if monthly price gains remain positive, which aligns with current inflation swap pricing.

Investor positioning and consensus expectations have increasingly favored higher Treasury yields on concerns around AI-related issuance, fiscal sustainability, and a hawkish-leaning FOMC. Should inflation data surprise to the downside, investors may be forced to reassess both the inflation outlook and the expected path of Fed policy. While much of the market’s attention remains focused on the risk of higher yields, the left tail of the yield distribution of lower yields may deserve greater consideration.