Judging the balance of risks is very different from pretending to foresee the future. -Mervyn King, Bank of England, Mansion House speech, 2005
Judging the balance of risks is very different from pretending to foresee the future.
The November 3 midterm elections were followed by a sharp decline in inflation expectations, only for a stronger-than-expected inflation report days later to raise expectations for Federal Reserve tightening. The one-year inflation swap, which reflects inflation pricing over the coming twelve months, fell from 2.44% the day before the election to 2.16% the day following the election. By November 9, it had declined to 1.94%, a drop of 50 basis points in just five trading sessions.
Energy markets offered the clearest evidence of what had changed. West Texas Intermediate crude oil fell more than 8% in the two trading sessions following the election, potentially reflecting expectations that Congress could constrain further escalation of the Iran war. Greater political scrutiny of AI infrastructure could also moderate capital spending and the associated demand for electricity, construction materials and equipment. The election may also reduce the likelihood of additional tariffs. All three could reduce future inflation pressures, although their influence on the market's repricing remains uncertain.
Then came November 10. The October Consumer Price Index increased 0.4%, exceeding expectations of 0.3%, while core inflation rose 0.3%, also above consensus. Core prices have risen at that pace for three consecutive months, reinforcing concerns about persistent underlying inflation. Fed Governor Christopher Waller had already indicated that a 0.3% core CPI reading would warrant consideration of a 50-basis-point increase. Two-year Treasury yields rose 17.6 basis points, their largest daily increase since April 2025, as investors increased the probability of a larger Federal Reserve rate hike in December.
Following the election, one-year inflation pricing fell sharply even as the expected federal funds rate twelve months ahead climbed toward 4.8%. The difference between the two measures has widened to approximately 2.6 percentage points. In blog 118 link, we examined how the initial Iran-war shock pushed both inflation expectations and expected interest rates higher. Eight months later, the relationship has changed: inflation expectations have retreated while expected interest rates have continued to rise. Higher expected interest rates can themselves contribute to lower inflation expectations, so the opposing movements are not inherently contradictory.
There are reasons to anticipate a meaningful decline in inflation. The Iran-war energy shock will begin entering the year-over-year comparison next spring. Market pricing reflects this anticipated decline, with CPI fixings falling from approximately 4% in January to 2.3% by May. Reduced pressure from energy, tariffs and AI-related investment could contribute to that outcome. Yet the decline is far from assured. Underlying inflation remains elevated, another energy shock is possible, and markets have frequently misjudged the future path of inflation.
The divergence leaves investors with considerable uncertainty about the future path of interest rates. If inflation declines as markets currently anticipate, expectations for additional Fed tightening could eventually reverse, particularly if economic growth also weakens. If inflation proves more persistent, inflation swaps may instead need to reprice higher, potentially reinforcing expectations for further tightening. Either outcome could materially change the interest-rate path now priced into the front end of the Treasury curve.
Between the Lines is a weekly blog by DoubleLine Portfolio Managers Sam Garza, Joseph Mezyk and Quant Analysts Fei He, CFA and Sunyu Wang that breaks down topical macro and market issues. For questions or suggestions please e-mail us at betweenthelines@doubleline.com. The views and opinions expressed herein are those of the authors and do not necessarily reflect the views of DoubleLine Capital LP, its affiliates or employees.
