Wall Street warning: Markets are too optimistic about inflation, beware the risk of a "hawkish surprise"

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As recent international trade tensions have eased, concerns about inflation in financial markets have cooled significantly. However, the latest analyses from Deutsche Bank and JPMorgan warn that this optimism may be premature. Investors may be underestimating multiple underlying upward pressures on prices in the economy, thus facing the risk of "hawkish surprises" from central banks being tougher than expected, which could impact stock and bond markets.

According to the "Chasing the Wind Trading Desk", Deutsche Bank pointed out in a report on November 3 that, benefiting from last week's trade easing, the US 1-year inflation swap recorded its largest weekly drop since May. At the same time, gold prices—traditionally seen as an inflation hedge—have also retreated from recent highs.

However, statements from central bank officials have been more cautious. After last week's FOMC meeting, the Federal Reserve sent out hawkish signals, with Chairman Powell suggesting that another rate cut in December is not set in stone. This contrasts with the market's dovish expectations and adds uncertainty to future policy direction. JPMorgan also emphasized in an October 31 report that the inflationary impact from tariffs, though lagged, will eventually be felt—and may prove more persistent than anticipated.

If inflation proves more resilient than the market expects, investors will face multiple risks. First, another bout of unexpectedly hawkish pivots from central banks could materialize, putting pressure on asset prices. Secondly, hard assets like gold—which perform well in inflationary environments—may again become favored. Finally, historical experience shows that hawkish turns by central banks are often accompanied by stock market sell-offs, as happened in 2015-16, at the end of 2018, and in 2022.

Deutsche Bank: Six Factors Could Keep Inflation Higher Than Expected

Despite the prevailing market optimism, Deutsche Bank believes there are multiple reasons to think the market may again be underestimating the stickiness of inflation—a scenario that has repeatedly played out in the post-pandemic cycle. The report lists six key factors:

Significant demand-side pressures: Recent global economic activity data have mostly exceeded expectations. The Eurozone’s October composite PMI preliminary reading hit a two-year high, US PMI data remain robust, and the Atlanta Fed's GDPNow model forecasts 3.9% annualized growth in Q3. A strong equity rally has also produced a positive wealth effect.
Lagged effects of monetary easing: Since September 2024, the Federal Reserve has cumulatively cut rates by 150 basis points, while the ECB cut 200 basis points from mid-2024 through mid-2025. It usually takes over a year for monetary policy’s effects to fully transmit, meaning these easing moves will have an impact through 2026.
Tariff impacts not fully realized yet: Though market turmoil peaked in April, many tariff measures only took effect in August. It takes months for these costs to pass through to end-consumers. Additional tariffs remain possible in the future.
European fiscal stimulus about to arrive: Planned fiscal stimulus in Europe will further boost demand pressure, while Eurozone unemployment is near a historic low and economic slack is much less than in the 2010s.
Oil prices rebounding: New sanctions and OPEC+’s decision to pause output increases are pushing oil prices higher again.
Inflation remaining above targets: Major economies continue to see inflation rates above central bank targets. US September CPI was strong, with core CPI's 3-month annualized growth hitting 3.6%. The Eurozone’s latest core inflation is 2.4%, above expectation and has remained above 2% since late 2021. Japan’s Tokyo CPI for October also beat expectations, while nationwide inflation in September was still 2.9%, remaining above the Bank of Japan’s target since early 2022.

Tariff Pass-Through Is Delayed, but Inevitable

Among the many inflation drivers, the impact of tariffs deserves special attention. JPMorgan’s report provides an in-depth analysis of this issue, believing that although the pass-through process is slower than anticipated, US consumers will ultimately bear the majority of tariff costs.

According to JPMorgan estimates, by late October, this year’s tariff revenue had already exceeded the same period last year by more than $140 billion and is expected to surpass by about $200 billion for the full year. These costs were initially partly absorbed by US companies squeezing profit margins, but surveys show that companies plan to pass on a greater portion to consumers.

The bank forecasts that US core CPI inflation may peak in Q1 2026 at 4.6% (quarter-on-quarter annualized). Tariffs are expected to cumulatively boost core CPI by about 1.3 percentage points before mid-next year.

The lag in tariff pass-through to consumer prices comes from phased implementation, importers using bonded warehouses to defer payments, time-consuming supply chain transmission, and companies using inventory to smooth prices. However, businesses cannot indefinitely bear compressed profits. Surveys by the New York Fed, Atlanta Fed, and Richmond Fed all show companies plan to pass on 50% to 75% of tariff costs. JPMorgan warns, if companies lack pricing power and cannot pass through costs, the result will be cost cuts through reduced investment and layoffs—which would also significantly drag down economic activity.

"Hawkish Surprises" Could Hit Stocks and Bonds Hard, While Gold and Other Hard Assets Regain Support

If the market’s inflation view is wrong, investors face threefold risks.

First, more "hawkish surprises" from central banks. Deutsche Bank’s report points out that the Federal Reserve's hawkish tilt last week serves as an example. This cycle, investors have repeatedly been caught off guard by pricing in rate cuts too soon. The report also notes that since September 2024, the Fed has delivered the fastest set of rate cuts in a non-recession period since the 1980s, leaving limited room for further easing.

Secondly, higher-than-expected inflation will once again support gold and other hard assets. The report notes that the recent retreat in gold prices happened alongside eased inflation concerns; once inflation proves more persistent, this trend will reverse. History shows that physical assets capable of preserving value usually perform well during inflationary times.

Lastly, along with being clearly negative for bonds, hawkish turns by central banks have historically often coincided with sharp corrections in stock markets. The report cites data showing that the Fed’s hawkish actions in 2015-2016 (first rate hikes), late 2018 (consecutive hikes), and 2022 (sharp hikes) coincided with significant selloffs in the S&P 500. Historically, rate hikes are one of the most common triggers for substantial US equity pullbacks.

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