The bond market is signaling rising price pressures in the US, as investors anticipate the economic policies of President-elect Donald Trump. The two-year break-even, a proxy for inflation expectations, has surged by one percentage point since September, reflecting the market's belief that Trump's plans for tariffs and tax cuts will fuel inflation.

Brace for a "Reflationary Cocktail"

Inflation Expectations Surge

The bond market is closely watching a key indicator that is pointing to rising price pressures in the US. The two-year break-even, which represents the gap between yields on Treasury bonds and inflation-linked bonds, has moved up by one percentage point since September to 2.6 percent. This suggests that investors expect average inflation to reach 2.6 percent over the next two years.The rise in break-evens has been prompted by economic data indicating stickier-than-expected price pressures, as well as Trump's rising electoral chances. As markets began to price in the potential for a Trump presidency, the break-even rate jumped following his emphatic win this week.

Traders Bet on a "Reflationary Cocktail"

Traders have been betting that Trump's plans for tariffs and tax cuts will provide a "reflationary cocktail" for the world's biggest economy. Barclays analysts have warned that this could lead to a more structural and protracted rise in inflation, rather than just a short-lived overshoot.Mark Dowding, chief investment officer at RBC BlueBay Asset Management, echoed this sentiment, saying, "We don't just look for a very shortlived overshoot on inflation [due to Trump's policies], this could be more structural and protracted."

Pimco Warns of "Reflationary" Policies

Bond giant Pimco has also cautioned about the potential impact of "reflationary" policies under a Trump administration. The firm's analysts have highlighted the risks of such policies, which could lead to a more sustained rise in inflation.However, some investors have questioned whether market expectations of inflation have been overdone, arguing that Trump's campaign rhetoric on tariffs and taxes may not be matched by his actions in office.

The Fed's Perspective

Federal Reserve chair Jay Powell indicated on Thursday that he was not yet concerned about the shift in inflation expectations, stating that they were broadly consistent with the central bank's 2 percent inflation target.This suggests that the Fed may be willing to tolerate a temporary overshoot in inflation, as it focuses on supporting economic growth and employment. However, the central bank will be closely monitoring the situation and may need to adjust its policy stance if inflation pressures become more persistent.

Inflation Expectations Rise in the UK

The bond market is also signaling rising inflation expectations in the UK, as investors readjust to the likely inflationary effects of Labour's first Budget. Two-year break-evens have ticked higher from 2.9 percent in mid-September to 3.1 percent, and slightly more for longer-term inflation expectations.This could be an "impediment to the Bank of England lowering interest rates much further," according to RBC's Dowding, as factors pushing up inflation, including a rise in employment costs from the Budget, may force the central bank to take a more gradual approach to future rate cuts.BoE governor Andrew Bailey has acknowledged the upside risks to inflation, saying the central bank would take "a gradual approach" to future cuts as it waits to see how price pressures develop. The minutes of the monetary policy committee highlighted "upside risks to goods and commodity prices from greater trade fragmentation," without mentioning Trump.Overall, the bond market is sending a clear signal that investors are bracing for a potential surge in inflation as a result of the economic policies proposed by President-elect Trump and the Labour government in the UK. Central banks will be closely monitoring these developments and may need to adjust their policy stances accordingly.