The big market bet that inflation will jump and the Fed will cut rates anyway

Inflation expectations are going up. Bond yields are going down.

Two-year inflation swaps (in which the buyer receives an inflation-linked payout) have jumped more than 25 basis points over the past two weeks in light of tariffs introduced by President Donald Trump, with promises of more to come as “Liberation Day” approaches. Meanwhile, two-year US Treasury yields have dropped 10 basis points over the same period.

It’s a curious combination not seen to this degree since the days following Russia’s invasion of Ukraine in 2022, an event which played a massive role in catalyzing generationally high inflation and a material downdraft in real economic activity.

Tariffs are a complicated issue for a central bank to manage, especially one like the Fed, which has a dual mandate for stable prices and maximum employment. Higher levies generally make things more expensive (pushing inflation up) but have a cooling impact on economic activity (which is negative for employment). Just look at autos: Deutsche Bank slashed its forecast for US auto sales this year by 500,000 because of higher prices.

Effectively, the mixed messaging suggests traders are saying the inflation will go up because of tariffs, but the central bank will still lower its policy rate nonetheless because of the downside risks for growth.

That’s in line with where the central bank seems to be, with the Fed inclined to think that tariffs will be more of a one-off shock than fuel for an inflationary spiral. During his most recent press conference, Chair Jerome Powell pointed out that tariff-induced inflation during Trump’s first term was “transitory.” And the economic forecasts presented by Fed officials at the March meeting show that while inflation estimates were raised, there were no changes to the median projection for core PCE inflation in 2026 or 2027.