U.S. interest rate traders are now ready for higher inflation

After months of shrugging off the prospects of persistently higher inflation in the U.S. interest rate traders are now coming to the realization that price pressures aren t going away and significantly readjusting their expectations.

So-called fixings, which trade as derivatives on the likelihood of where future consumer-price gains will land, are now at levels that imply a headline CPI print of 5.9% in October and 6.4% in both November and December, said Tim Magnusson, partner and senior portfolio manager at Garda Capital Partners LP in Minneapolis. The October reading alone would be the highest level in more than 30 years.

The shift in thinking comes after months in which financial markets and Federal Reserve policy makers have consistently been caught off guard by the strength and persistence of price pressures.

The 1 year forward inflation market, for example, was priced a year ago for inflation to be below 2% by now, compared to its September level above 5%, and is currently priced for realized inflation to be around 3.77% over the next year. Meanwhile, a five-year measure of inflation expectations hit its highest level since April 2005 on Wednesday.

The market and the Fed have continually under-estimated how high inflation could go in 2021, Magnusson said via email on Thursday. The FOMC s thinking is clearly evolving on this topic, but the rates market has woken up and started to price for hikes in 2022, which makes a lot of sense to us. While actual CPI rises could come in lower than what s implied by the fixings, it is doubtful that they do given what we know about prices like used cars, rents, food, energy, etc. Magnusson, whose firm manages $7.5 billion in assets, said Magnusson.

Thursday's $19 billion 5 year TIPS auction, which produced strong demand, was evidence of how much investors are looking for inflation protection ahead of the next Fed policy meeting in early November.

On Thursday, most U.S. Treasury yields drifted higher, with the 10-year yield TMUBMUSD 10 Y hovering around 1.67%.

U.S. stocks have been consolidating Thursday after this week s rally, with the Dow industrials DJIA, marginally lower and the S&P 500 SPX, down by 0.3% or more than 100 points. The Nasdaq Composite Index COMP was up 0.4%.