Are Markets Underestimating the Looming Inflation Risks from Tariffs and Fiscal Policies?

The current market environment is a study in contrasts. While equities trade near record highs and bond yields creep upward, the underlying forces of inflation and macroeconomic risk remain underappreciated by investors. The disconnect between market complacency and the realities of policy-driven inflationary pressures—particularly from tariffs and fiscal expansion—demands closer scrutiny.

The Inflation-Valuation Paradox

As of July 2025, the 5-Year and 10-Year breakeven inflation rates stand at 2.53% and 2.43%, respectively, both above their long-term averages. These figures, derived from Treasury Inflation-Protected Securities (TIPS) spreads, suggest that markets expect moderate inflation over the next decade. Yet, the U.S. Economic Forecast Q2 2025 warns of a 3.6% core PCE deflator by year-end due to persistent tariff policies. This gap between market expectations and policy-driven reality highlights a critical miscalculation: investors are pricing in a return to “normal” inflation while policymakers are embedding structural inflationary shocks.

Equity valuations, particularly for the S&P 500, reflect this complacency. The index's forward P/E of 22.43 appears reasonable, but its P/E10 (CAPE) of 36.1—a level not seen since the dot-com bubble—reveals a far more precarious picture. This premium is justified by expectations of aggressive Fed rate cuts, yet these forecasts ignore the inflationary drag from tariffs and fiscal deficits. For instance, the One Big Beautiful Bill, projected to add $2.4 trillion to the deficit over a decade, could force the Fed into a tighter policy stance than currently priced in.

Tariff Tensions and the Yield Curve

The 10-Year Treasury yield, now at 4.44%, is a barometer of this tension. While rising yields reflect inflation expectations, they also signal investor demand for compensation against policy uncertainty. The U.S. Economic Forecast's downside scenario—a 25% average tariff regime—could push the 10-Year yield above 5%, triggering a bond market selloff and a 1.7% GDP contraction in 2026. Yet, the market remains sanguine, with investors assuming the Fed will pivot to rate cuts as soon as inflation moderates. This assumption is flawed: tariffs and fiscal policy create structural inflation, not cyclical spikes, meaning the Fed's tools may prove insufficient to offset their effects.

Safe-Haven Assets: Gold vs. Bitcoin

The performance of traditional and digital safe-havens further underscores market complacency. Gold, at $3,350/oz, has underperformed expectations, declining 0.4% despite rising inflation. In contrast, Bitcoin has surged to $123,000, driven by institutional inflows into spot ETFs and regulatory optimism. This divergence is telling: gold, a traditional inflation hedge, struggles to gain traction, while Bitcoin's narrative as a “digital gold” resonates with investors seeking protection against currency debasement.

Bitcoin's rally—supported by $2.7 billion in ETF inflows in a single week—suggests investors are betting on a world where monetary policy and fiscal expansion erode fiat currency value. Gold's relative underperformance, meanwhile, points to a loss of confidence in its utility as a hedge in a digital-first, policy-driven inflationary environment.

The Path Forward: Reassessing Complacency

The risks of underestimating inflation are clear. Tariffs and fiscal policies are not temporary distortions but long-term structural forces that could push inflation above the Fed's 2% target for years. For investors, this means:
1. Rebalancing Portfolios: Defensive sectors (e.g., utilities, healthcare) and inflation-protected assets (TIPS, commodities) should be overweighted.
2. Monitoring Yield Curve Signals: A steepening yield curve (long-term yields rising faster than short-term) could signal impending inflation shocks.
3. Capitalizing on Safe-Haven Divergence: Bitcoin's institutional adoption offers a compelling alternative to gold, but investors must weigh its volatility against its inflation-hedging potential.

In conclusion, the market's current complacency is a double-edged sword. While equities trade at all-time highs, the inflationary tailwinds from tariffs and fiscal expansion could force a sharp repricing of assets. Investors who recognize this disconnect now may find themselves better positioned for the volatility ahead. The question is not whether inflation is coming—it is—but whether markets are ready for it.