On Tuesday, a rare divergence emerged in the U.S. bond market, with short-term and long-term inflation expectations moving clearly in opposite directions, reflecting investors’ divergent views on the inflation outlook. Currently, the market’s expectation for inflation over the next two years has risen significantly, while expectations for long-term inflation have remained stable. This divergence suggests that investors generally believe the inflationary pressure stemming from the Iran conflict is more transitory in nature, while still maintaining confidence in the Federal Reserve’s long-term ability to control inflation.
Data shows that the two-year breakeven inflation rate is now significantly higher than the ten-year rate. On Tuesday, the two-year indicator stood at approximately 3.3%, while the ten-year was around 2.36%, resulting in a spread of nearly 0.94 percentage points—more than three times the average of the past five years and close to the highs seen during the inflation scare about a year ago. Analysts point out that this pattern of “rising near-term inflation and anchored long-term inflation” highlights the market’s relatively rational assessment of the current conflict’s impact.
Based on market pricing, investors expect U.S. inflation to approach 4% over the next few quarters. Padhraic Garvey, Head of Research for the Americas at ING, believes this expectation reflects the significant upward pressure on near-term inflation from rising energy prices. Nevertheless, since the outbreak of the Iran conflict, the ten-year inflation expectation has risen only modestly by about 0.10 percentage points, while the two-year expectation has surged by nearly 0.48 percentage points. Analysts note that if the market were truly concerned that the Fed might cut rates excessively due to policy pressure, thereby triggering persistently high inflation, long-term inflation expectations would be unlikely to remain this stable.
Regarding the near-term policy path, significant uncertainty remains in the market. As inflation expectations rise, investor expectations for a Fed rate cut at the April meeting have all but disappeared. According to the CME Group’s FedWatch Tool, approximately 97.4% of market participants now expect the Fed to keep interest rates unchanged, with only a few betting on a rate hike. At the same time, if persistently high oil prices weigh on consumer spending and corporate hiring, leading to an economic slowdown or even a recession, the market still sees room for future rate cuts. Analysts suggest that in such a scenario, the Fed might be forced to pivot back to easing policy.
Separately, according to the New York Fed’s monthly Survey of Consumer Expectations released on Tuesday, the median expectation for inflation one year ahead rose to 3.4% in March, up 0.4 percentage points from February—the largest one-month increase in a year. The three-year inflation expectation edged up to 3.1%, while the five-year expectation held steady at 3%. The survey period coincided with a rapid escalation in geopolitical tensions following military actions by the U.S. and Israel against Iran. Consumers expect gasoline prices to rise by 9.4% over the next year, a sharp increase of 5.3 percentage points from before the conflict and the highest level since March 2022. Food prices are expected to rise by 6%, up 0.7 percentage points from February.
