Goldman: Traded Inflation Compression Reflects Right Tl Reduction

Goldman Sachs note that “the month-to-date decline in U.S. rates has been almost entirely an inflation story, with real rates comparatively sticky even as inflation pricing has moderated significantly from late April highs (falling 35-40bp at the 5-Year point and 30bp at the 10-Year point). This pressure has been somewhat more acute in cash breakevens than in inflation swaps, suggesting that a flow imbalance earlier this month may have played an amplifying role, and could therefore partially unwind as yields stabilize. However, in our view, fundamentals are also at play. While the very front-end of the inflation curve has been comparatively sticky, the largest downgrade of inflation forwards has come in 2023-2025 pricing. We think this largely reflects the shift in focus more firmly towards growth/recession worries and away from inflation risks; indeed, inflation options markets suggest as much, indicating a relative downgrade of right tail inflation risks of late. Given the repricing, we see a tactical case building for an inflation-led selloff on diminished growth concerns and/or firmer than expected inflation news that refocus markets on right tail risks. That said, the current market-implied inflation path is comparable to our economists’ baseline forecasts; absent a material shift in data away from this baseline, the path to higher nominal yields likely rests on real rates.”