Investors are recalibrating their expectations for Federal Reserve rate cuts after an unexpected surge in consumer inflation.

Fed futures now reflect just 36 basis points of cumulative rate cuts by year-end. This implies only a 50% probability of two reductions, according to CME FedWatch tool.

Markets increasingly see just one rate cut as the most likely scenario, versus the two-cut path indicated in December.

Betting odds tracked by the CFTC-regulated Kalshi currently assign a 25% probability to two rate cuts. The chances of one cut or no cut at all stand at 22% and 17%, respectively.

Inflation Concerns Resurface

The University of Michigan’s latest consumer sentiment survey triggered fresh alarm, showing a sharp jump in inflation expectations that surprised analysts.

The one-year inflation expectation surged to 4.3%, rising one full percentage point from last month and reaching its highest level since November 2023.

“Many consumers seem concerned that high inflation will return within the next year,” the University of Michigan stated in its report.

President Donald Trump pledged to raise tariffs on major U.S. trading partners, on top of a 25% tariff on aluminum and steel imports.

The U.S. five-year breakeven inflation rate—a key gauge of market-based expected inflation—rose to 2.59% on Monday. That’s up from 1.89% in September 2024, according to TradingView data.

This suggests investors anticipate inflation to average well above the Fed's 2% target over the next five years.

“Given the considerable policy uncertainty caused by the return of global trade protectionism and the return of mercantilism among the G-7 nations, it is not certain that inflation expectations will remain well anchored,” said Joseph Brusuelas, economist at RSM US LLP.

“The sudden jump in inflation expectations isn't a coincidence. Trump’s tariff threats toward Canada, Mexico, China, and the EU are fueling inflation concerns. Despite stocks holding near record highs, gold is rallying, and TIPS have outperformed Treasuries for the past month—clear signs that investors are positioning for inflation,” said analyst Michael Gayed, CFA.

Nonfarm payrolls rose by 143,000 in January, slightly below consensus due to weather disruptions, but revisions from previous months added 100,000 jobs. The unemployment rate unexpectedly dropped to 4.1%, while wage growth accelerated.

“The labor market appears to have stabilized around full employment, reinforcing our view that the Fed's rate-cutting cycle is over,” said Bank of America economist Aditya Bhave.

Goldman Sachs economists echoed this sentiment. Markets still underprice the inflationary impact of tariffs, indicating that investors may not be fully accounting for persistent price pressures in their rate forecasts.

“Friday's jobs report reinforced the argument that economy is in a place that can allow the Fed to be patient until it has better confidence in underlying disinflation and better clarity into (trade and fiscal) policy outcomes,” wrote Goldman Sachs economists.

Inflation hedges have delivered strong gains over the past month. The iShares TIPS Bond ETF ( TIP ) is up nearly 3%; the SPDR Gold Trust has surged 9%.

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