Bond traders are underestimating how much Tuesday’s Consumer Price Index report will show the inflation rate dropped last month, according to Citigroup Inc. strategist Raghav Datla.

Datla’s assessment is partly based on comparing traders’ positioning now relative to back in January. Just five months ago, the market was coming off two consecutive lower-than-forecast CPI prints. Yet inflation expectations over the next couple of years are currently higher than they were at the beginning of 2023, despite tighter financial conditions, lower year-over-year inflation and higher unemployment and jobless claims, he notes. 

“We do not think markets have been adequately pricing downside risks for inflation heading into the May inflation release,” Datla wrote in a report published Sunday. A lower-than-forecast print is likely to propel a decline in front-end inflation expectations, he said, recommending an inflation-swap steepner trade to profit from such an outcome.

Tuesday’s CPI report for May comes just a day before the Federal Reserve’s policy decision, where traders are wagering officials will hold interest rates steady between 5% and 5.25% for the first time in 15 months. Still, swaps show roughly 24 basis points of additional tightening is priced by the July meeting. 

Datla notes that core inflation, which excludes volatile food and energy prices, is primed to fall meaningfully below 0.4% month-over-month in May for the first time since November, defying economist forecasts for the rate to remain steady. The move is likely to be driven by a return of goods inflation below 0.4%, after it spiked in April due in part to a jump in used car prices, he said.

CPI has been trending lower after peaking above 9% year-over-year last June. With the commodity price shock fading, the headline rate is forecast to slow to 4.1% in May from 4.9%, while the core rate is seen easing to 5.2% from 5.5%. 

Bond traders have overestimated month-over-month headline inflation heading into four of the last seven CPI releases, Datla noted in the report.