The Fed and Inflation Expectations Diverge

Inflation expectations have fallen sharply while markets have raised expectations for Federal Reserve tightening, creating an unstable signal for interest rates.

• The one-year inflation swap fell from 2.44% on November 2 to 2.16% on November 4 and 1.94% by November 9, a 50-basis-point decline in five trading sessions.
• West Texas Intermediate crude dropped more than 8% in the two sessions after the November 3 midterm elections, as markets considered lower risks from the Iran war, AI infrastructure spending and tariffs.
• October CPI rose 0.4% on November 10 against expectations of 0.3%, while core CPI rose 0.3% for the third consecutive month; two-year Treasury yields jumped 17.6 basis points, the largest daily increase since April 2025.
• One-year inflation pricing moved lower while the expected federal funds rate twelve months ahead approached 4.8%, widening the gap between the measures to approximately 2.6 percentage points.
• CPI fixings imply a decline from approximately 4% in January to 2.3% in May as the Iran-war energy shock enters annual comparisons, although elevated underlying inflation and another energy shock could disrupt that path.

Takeaway: A further fall in inflation could reverse expectations for additional Fed tightening, especially if growth weakens, while persistent inflation could push inflation swaps and front-end Treasury yields higher.