Goldman: Buy U.S. Inflation On Too Low Front-End CPI & Med-Term Risk Premia

Goldman Sachs note that “the rally in U.S. rates from the October yield peaks has been nearly equal parts real and inflation components, with 10-Year breakevens revisiting their lowest levels of the year.”

• “While partly supported by back-to-back negative inflation surprises, the compression has been more than simply a mechanical reset.”
• “For front-end forwards, the market is now implying 2023 inflation of 2.6%, down about 25bp over the last month and a half, and some 50bp below our economists’ forecast for next year. Further out, 5y5y breakevens have returned to the range seen last cycle and hover only modestly above 2%.”
• “We think the declines in traded inflation are excessive for two reasons: 1) the pricing lower in the near-term path looks overdone, particularly since recent negative surprises have largely come in more volatile categories, and 2) our economists’ forecast that inflation will sustain levels materially higher than the average of the prior cycle.”
• “The latter, coupled with the Fed’s shift to a more cautious approach argue for a higher range for longer horizon forwards, with more inflation risk premium this cycle compared to the last. Given this, we think risk/reward has shifted firmly in favour of buying U.S. inflation, and recommend going long 10-Year breakevens.” They recommended opening the trade at 2.15%, with a target of 2.40% and a stop at 1.95%.