Is it cake? - the inflation episode

In the TV show Is It Cake?, contestants craft cakes to look like everyday items: phones, handbags, even shoes. Judges then try to guess: is it cake, or is it real? The winner is the one who fools them.

Since his January inauguration, President Trump has been throwing ingredients into his economic mixing bowl, hoping to bake up some growth. It’s been hit or miss. His tax bill rose without much fuss, but the Elon Musk-led Department of Government Efficiency seems to have collapsed like a soggy soufflé. The key element, though, has been tariffs. After March’s delay, we now have a clearer sense of how the trade landscape might look in the medium term.

The Trump economic cake is out of the oven. And it’s time for the big reveal.

And just like the show, expectations are high. But instead of shouting “is it cake?” markets are asking – “is it inflation?”

The year so far…

Aside from a brief lull in April, financial markets have been headline-heavy this year. Yet global government bond yields have remained surprisingly well-behaved. Putting to one side a few dramatic gyrations around Trump’s ‘Liberation Day’, yields have been treading water - or, to stay on theme, gently kneading dough. Ten-year US yields have remained within a 20-basis point range.

While we’ve been patiently waiting for the tariff smoke to clear, the US economy has been cooling and the labour market is starting to soften (see August’s terrible numbers). Employment sentiment is deteriorating. July’s revisions to the labour market data painted a somewhat unsavoury picture.

The US Federal Reserve (Fed) is preheating the oven for a September rate cut. President Trump has been cajoling Chair Powell to lower the heat for months. Equity and credit markets are also ready for a slice of lower rates.

Now all that’s left is the big inflation reveal.

It can go one of two ways.

No inflation – no worries

Tariffs are expected to push prices higher, with US importers and consumers likely to feel the pinch. But this is already baked into market expectations. Some – including the US administration – argue it’s a one-time price level shift. If that shift stays contained, the Fed’s cutting cycle can continue uninterrupted.

Some investors seem confident. Equity markets are at all-time highs, and credit spreads are historically tight. The rates market has fully priced in a September cut. Beyond that, expectations are for the federal funds rate to fall from today’s 4.33% to below 3%.

If inflation proves benign in the coming months (a big if), we think base rates could go even lower than forecast. Falling prices would enable markets to reflect a weakening labour backdrop and contained inflation – aligning both sides of the Fed’s mandate and supporting further cuts.

Higher inflation – we have a problem

If inflation stays high – or rises further – we’ve got a problem.

Rates have been restrictive since mid-2022 in an attempt to cool inflation. And while monetary policy is known for its “long and variable lags”, most proponents don’t expect those lags to stretch beyond two years.

There’s a touch of irony here: a dovish Fed now seems inevitable, regardless of the data. The composition of the Fed is changing, with a more Trump-friendly, dovish Chair and a fiscal regime that’s both expensive and expansive. Fiscal dominance over monetary policy is starting to look plausible.

The Fed could justify cutting by looking through inflation and focusing on the deteriorating labour market, but questions about the primacy of the “power of the purse” would only grow louder. The Fed cutting interest rates in September while inflation is accelerating would turn up the volume further.

It would also pile pressure on longer-maturity bonds. Term premia are already rising in the US, as investors question the Trump administration’s actions. A Fed that tolerates higher inflation would likely push long-term yields higher still.

Having our cake and eating it

In our view, both inflation scenarios point to further steepening of the US yield curve – bull-steepening if inflation falls and bear-steepening if it doesn’t. Mounting global concerns around government debt only reinforce this outlook. Just witness the recent moves higher in long-term Japanese and UK yields.

Politics is a key source of uncertainty, amplified by the sheer volume of bond issuance and a drop in natural demand. The UK budget is in sight, and we’ll be writing more about that soon.

Europe offers yet more opportunity for curve steepening. We’ve previously written about the seismic shift in German issuance. The proof will be in the pudding (!). Elevated borrowing costs, a subdued economic growth outlook, and pension reform all point to a steep yield curve.

In other words: investors really can have their cake and eat it.

What about yields?

Well, it all depends on how that cake tastes.

If inflation briefly spikes before cooling, market participants – across equities or fixed income – will breathe a sigh of relief. Ten-year yields could drift gently lower. But if that cake has a bitter inflation tang, risk markets might feel the pain more than outright bond yields.

In the short term, we expect yields will decline while curves steepen, though we’re ready to react to any signs of stickier inflation.

Whatever the flavour, global yields are likely to stay elevated. Central banks will remain active, and government bonds will continue to drive the investment narrative.

Bon appétit.