A look under the hood into what is driving the U.S. bond market sell-off since the Fed"s hawkish tilt last week suggests investors are pricing in higher interest rates more than higher inflation. There"s been plenty of reason to worry about accelerating inflation and input prices all year. But for all the noise about a return to the 1970s and investors running fearful of price spikes, you would be in the red on any benchmark inflation hedges bought at the start of the year. The trend was underlined over the past week. The surge in longer-term yields and curve steepening since the Fed"s Sept. 22 meeting has been driven largely by rising "real" yields, while breakeven rates - a cleaner gauge of inflation expectations - have moved up less dramatically and remain in the broad ranges seen since the Spring. So far at least, inflation expectations as measured by breakevens from five- through 30-year maturities have only backed up to where they were last month. They remain markedly lower than they were in May. What"s more, inflation expectations according to forward swap rates - an even cleaner measure stripping out any bond market distortions from the Fed"s QE - show a similar picture: higher, but still below mid-year levels. If the bond market genuinely feared current supply-driven, elevated inflation was about to morph into a permanent, demand-driven phenomenon, breakevens would be marching higher just as fast as nominal yields. If not faster. That said, there are still valid grounds for concern. Brent crude oil is above $80 a barrel for the first time in three years, doubling in the last 12 months. Core inflation scaled 4% recently for the first time in nearly 30 years. Headline inflation slowed in August, but it is still above 5%. Phillip Toews, CEO of Toews Asset Management, overseeing $2 billion of assets, is convinced financial markets are being too complacent. He puts a 50-50 probability on double-digit inflation ahead. "We"re in denial," he warns. (NOT SO) HOT TIPS Establishing the driving force behind rising Treasury yields is important because it indicates how comfortable - or otherwise - investors are with the broad inflation outlook, and give better insight into policymakers" thinking. As long as breakeven rates remain contained, there is a strong case to be made that the bond market is relatively relaxed with the outlook, the Fed is not behind the curve and rates can rise as planned without disrupting financial markets. This calls into question the narrative that has built up in recent months and which accelerated sharply last week: that inflation is threatening to get out of control, forcing the Fed into a reactive rather than proactive tightening cycle. This is being fueled by global supply chain bottlenecks caused by the COVID-19 pandemic, from chips shortages to container ships unable to dock at port. Some measures of consumer and business inflation expectations are also spiking higher. Fed officials, however, insist this is transitory, although possibly longer-lasting than they had previously believed. The Fed last week said that nine of 18 policymakers expect rates to start rising in 2022, up from seven in June, and that the median projection has shifted toward a swifter pace of tightening. They expect inflation to remain above the Fed"s 2% target through 2024. read more But buying protection against inflation, at least this year and via Treasury Inflation-Protected Securities, has been a risky trade. Ten-year TIPS are down around 1.5% this year and 30-year TIPS are off almost 7%. Since the Sept. 22 Fed meeting, they are down around 1% and 4%, respectively. This has meant "real" yields, which account for inflation, have jumped. The 10-year real yield was a record low -1.2% in early August. It is now -0.85%, representing an increase of 35 basis points. That is almost exactly the same magnitude of increase in the nominal 10-year yield over the same time frame, to 1.53% from 1.18%. Coupled with the slower rise in breakevens, this suggests investors are re-pricing the Fed"s reaction function rather than a permanent higher rate of inflation. A JP Morgan client survey last week showed that 54% think supply constraints are temporary, and 43% expect them to become a persistent feature. Even if that balance reverses, breakevens suggest investors remain confident enough that the Fed will act swiftly enough to contain a more damaging lift-off in inflation.