US Rates Watch: Expect hikes to trigger real yield curve inversion

Research evidence excerpt

US Rates Watch: Expect hikes to trigger real yield curve inversion

anchored and potentially decline on a hawkish Fed, particularly one focused on

tightening financial conditions.

We continue to hold a 1y2y inflation swap curve flattener (initiated 28 May at -19bps,

current -13bps) with a lot of good news on oil well priced. Risk to the trade is continued

collapse in oil prices. Much of our conviction for hawkish Fed reaction function impact

on curve composition can be traded in forwards as we discuss below. This allows us to

step over near term oil-related volatility and offers favorable roll down.

Extent of inflation problem depends on what you look at…

Inflation looks very different depending on the lens. Warsh’s push to return inflation to

2% appears more urgent in core PCE, which has moved back toward mid‑’23 highs, than

in core CPI, which has largely remained range‑bound over the past year (Exhibit 5). This

divergence reflects a negative wedge between the two measures that we do not expect

to reverse in the near term.

Market pricing similarly lacks that urgency: front‑end inflation forwards such as 1y1y are

still below 2.5% and far less inverted than during the 2022–23 hiking cycle (Exhibit 6). If

the Fed follows through with hikes to bring down PCE, the implication is for further

compression in front‑end inflation forwards that trade with risk assets (see: 1, 2 step).

Exhibit 5: 6m annualized core CPI & PCE Exhibit 6: Inflation swap forwards

Core PCE has broken out of recent range while core CPI is more anchored Forward inflation measures show lower upside inflation risk vs ’22 & ‘23

8% Core CPI Core PCE 1y1y 2y1y 3y1y

3.8% 7%

6%

3.2% 5%

4%

3% 2.6%

2%

1% 2.0%

Jan-21 Oct-21 Jul-22 Apr-23 Jan-24 Oct-24 Jul-25 Apr-2 Jan-21 Jan-22 Jan-23 Jan-24 Jan-25 Jan-26