CPI: A consensus core might not be enough

The S&P 500 saw a modest decline on Monday after achieving record highs last week, culminating in a historic close above 5000 for the first time on Friday. Investors appeared to exercise caution by reducing some risk ahead of the release of potentially market-moving US inflation data scheduled for Tuesday.

It's a common market phenomenon for the dominant trend to revert ahead of significant risk events. Considering the remarkable rally in the S&P 500 (SPX) this year, it's reasonable to anticipate a pullback in the SPX as investors adjust their portfolios accordingly to mitigate potential risks associated with the upcoming event. However, there could be more than just meets the eye.

Both markets and investors are clearly well caffeinated, pushing the S&P 500 benchmark to record heights in 2024, driven by a robust U.S. economy and the possibility of rate relief later this year. The S&P 500 has crossed the 5000 mark for the first time, up by 5% this year and a remarkable 21% above the recent dip in late October (just three months ago)

Not all are in demand on the Fed dovish pivot; however, the bond market is feeling the weight of ongoing supply, with 10-year yields holding close to a 2-month high of 4.17-18, up 30 basis points in the past seven sessions.

Meanwhile, the US CPI release should confirm that the disinflation trend continues. But with absentee foreign bond buyers shunning US bonds, that's probably not enough for bond markets, as a consensus month-on-month core outcome would still be too hot for comfort at the Fed.

Indeed, the year-on-year inflation rates are expected to decline with a high degree of certainty. This phenomenon is primarily due to the base effect. In January 2023, there was a 0.5% increase compared to the previous month. Therefore, any figure lower than this will naturally decrease the year-on-year inflation rate for both headline and core metrics.

While a 0.2% reading for the headline figure is anticipated and should be absorbed favourably, the core inflation figure at 0.3% is somewhat ambiguous. The concern is that this figure could potentially lead to a higher annualized rate, which may not be favourable. Hence, in a highly overcaffeinated market, a downside miss on the core is likely needed for doves to take flight, bond yields to rally, and probably stocks too. So if we get the anticipated 0.3%, which is well baked into market sentiment, we will unlikely get anything close to an ebullient cross-market reaction.

A 0.4% outcome would be a huge negative surprise in the worst-case scenario. Unfortunately, then all bets are off — figuratively and in this context quite literally, as there is a lot of money backing the disinflation trend. The dreaded top side beat would throw ice water on the easing inflation story, send May cut probability tumbling south of 50% and upend a stock market rally looking for more boost juice from a dovish Fed.

The US isn’t out of the woods yet on the inflation front, even if markets are keen to pretend otherwise.