Deutsche Bank strategist Henry Allen argues that, based on current upside pressures on prices, investors are underestimating the magnitude of interest rate hikes required to contain inflation. He points to a "fundamental disconnect" between the limited rate hike expectations priced in for the Federal Reserve and the European Central Bank on one hand, and escalating inflation pressures on the other, which he believes cannot persist.

Data from the Institute for Supply Management (ISM) released last Thursday showed that price increases for raw materials in the services sector in August reached levels not seen since the onset of the COVID-19 pandemic, a period when U.S. CPI was running at 5%. "Either inflation comes down, or rate pressure will persist," Allen wrote in a research note published Monday.

The prolonged conflict in the Middle East continues to drive up oil and natural gas prices, while ongoing supply chain disruptions and extreme weather events have pushed food and metal prices sharply higher. Despite a warning last month from Federal Reserve Chair Kevin Warsh that inflation has not shown meaningful deceleration, swap markets are still pricing in only two rate hikes by the U.S. central bank through the end of July 2027.

"The shallow rate hike cycle the market continues to price for the Fed is inconsistent with their past tightening cycles," Allen added, noting that in four of the past five years, investors have underestimated the aggressiveness of policymakers' actions.