Inflation Expectations Unmoored: A Potential Second Wave Looms, Threatening Markets

Inflation expectations are becoming unmoored, with a 5-year CPI swap breaking out of a 2-year base. This could have significant consequences, as it may indicate a second wave of inflation that could shock the markets.

Inflation expectations are becoming increasingly unmoored, with a 5-year CPI swap breaking out of a 2-year base, signaling a potential second wave of inflation that could shock the markets. This breakout, which is unprecedented in recent history, suggests that interest rates are likely to rise significantly [1].

The cause of this breakout is multifaceted, with tariffs, rising commodity prices, and increasing shipping rates being key contributors. The Baltic Dry Index, which measures the cost of shipping raw materials, surged above 2,000 for the first time since the fall of 2020, indicating a significant increase in shipping costs. Additionally, prices for commodities like copper and iron ore, which are historically tied to the Baltic Dry Index, have been on the rise [1].

The 5-year CPI swap is now trading at its highest level since the spring of 2023, a clear indication that inflation expectations are shifting. This breakout in inflation expectations is not just a minor deviation; it suggests a fundamental change in market sentiment. The market is warning that after two years of consolidation, inflation is not only bottoming out but is heading higher [1].

The implications of this are significant. Treasury rates, such as the 10-year, tend to trade in line with CPI swap pricing. Therefore, the recent surge in CPI swap pricing suggests that the 10-year rate should be heading higher, potentially considerably higher, perhaps not only to their highs in October 2023 but possibly beyond [1].

The market, overall, from rates to stocks and credit, is not prepared for a second inflation spike. Valuations are too high, and spreads are too tight. The entire market is priced for perfection, and we all know we live in a far-from-perfect world [1].

Damage from Donald Trump's tariffs is expected to be felt in the next few months, with the Fed unlikely to cut interest rates until it surveys the extent of the impact [2]. Inflation is already starting to "lift-off" in consumer goods, and services inflation is expected to follow soon. This could lead to a stagflation shock, where inflation rises while economic growth slows, making it one of the worst-case scenarios for the economy [2].

Investors should be cautious and monitor the situation closely. Companies like Fastenal (FAST), which have shown resilience in navigating inflationary pressures, may continue to perform well. However, the overall market sentiment is likely to be volatile as the second wave of inflation unfolds [3].

References:
[1] https://seekingalpha.com/article/4802282-a-second-inflation-wave-may-be-coming-and-could-shock-the-markets
[2] https://www.businessinsider.com/inflation-trump-tariffs-impact-prices-stagflation-us-economy-slok-apollo-2025-7
[3] https://www.ainvest.com/news/fastenal-s-q2-earnings-beat-signals-sustainable-growth-amid-inflationary-pressures-25071010f92d4080559621f6/