While economists focus on the firmer 'core' inflation, financial markets that trade inflation (like TIPS and swaps) price off the 'headline' number. This headline figure has consistently surprised to the downside for 14 of the last 18 months, creating a bearish dynamic for inflation-linked assets.

Despite a downside surprise in CPI, the Fed's preferred inflation gauge, Core PCE, is still rising. This growing negative wedge between the two metrics leads to a more hawkish Fed policy than CPI alone would suggest, creating a negative outlook for TIPS in the near term.

Bond markets are not pricing in higher long-term inflation; expectations remain anchored near the Fed's 2% target. However, the uncertainty around future inflation has widened significantly due to shocks and policy shifts. This increased risk of volatility drives the higher "term premium" demanded by investors.

When inflation risk dominates markets, the traditional negative correlation between stocks and bonds breaks down. Bonds (duration) stop acting as a reliable hedge for equity drawdowns. In this environment, investors must seek explicit convexity hedges, like call options on oil or inflation breakevens, rather than relying on a balanced portfolio.

A common misconception is that Fed rate cuts lower all borrowing costs. However, aggressive short-term cuts can signal future inflation, causing the 10-year Treasury yield to rise. This increases long-term rates for mortgages and corporate debt, counteracting the intended economic stimulus.

Despite soaring nominal rates, the inflation breakeven rate (TIPS spread) has remained flat. Harley Bassman interprets this as a clear signal that the market's primary concern isn't inflation, but rather the US government's massive fiscal deficits and eroding trust.

The Fed's primary inflation gauge, Core PCE, is running nearly 100 basis points hotter than Core CPI, the benchmark for inflation markets. This creates a risk of the Fed overtightening policy based on sticky PCE data, which could lead to a weaker-than-expected inflation outcome for CPI and thus cause underperformance for CPI-linked bonds.

The Fed's tool of raising interest rates is designed to slow bank lending. However, when inflation is driven by massive government deficits, this tool backfires. Higher rates increase the government's interest payments, forcing it to cover a larger deficit, which can lead to more money printing—the root cause of the inflation in the first place.

When a central bank signals a series of rate hikes, investors delay buying bonds, waiting for rates to peak to lock in the highest possible yield. This counterintuitive behavior means an initial rate hike can fail to attract capital and support the currency, as it creates an expectation of better returns in the future.