Morgan Stanley Warns of Potential Inflation Rate Inversion

Morgan Stanley's rate strategists have issued a warning that the upcoming Consumer Price Index (CPI) data, coupled with a decline in oil prices, could potentially lower the bond market's expectations for inflation over the next two years. Led by Aryaman Singh, the team advises clients in the inflation swap market to prepare for a scenario where the two-year inflation rate, currently around 2.79%, could fall below the ten-year inflation rate, which is approximately 2.48%. This situation has not occurred since the election day, where short-term inflation expectations have consistently been higher than long-term expectations.

If the CPI data released on Wednesday shows that inflation is lower than economists' forecasts, this trading strategy could quickly achieve its goal. The strategists note that the May CPI data is "crucial for understanding the initial impact of tariffs on core goods prices." Economists surveyed predict that the overall CPI is expected to rise by 0.2% month-over-month, while the core CPI, excluding food and energy, is expected to rise by 0.3%. However, the inflation swap market prices these increases at 0.12% and 0.23% respectively, with strategists indicating that this measure is a more accurate predictor of CPI data.

Additionally, the report states that the one-year inflation swap rate has been on a downward trend, indicating that market participants are ruling out the possibility of an effective increase in tariff rates in the future. Strategists predict that the current two-year CPI swap rate, which is 31 basis points higher than the ten-year rate, could fall to just 10 basis points higher. However, they advise exiting the trade if the spread widens to 45 basis points. Risks associated with this trading strategy include an unexpected rise in core goods CPI and an increase in effective tariff rates.

Morgan Stanley also points out other favorable factors for this trading strategy. Based on signals from global stock markets and financial conditions, the ten-year inflation expectation appears poised to rise. Furthermore, the firm's commodity strategists predict that the decline in oil prices will have a greater impact on short-term inflation expectations than on long-term expectations.

Ask Aime: How does Morgan Stanley's warning on CPI data and oil price decline affect bond market expectations?