How should the market react to US CPI?

Monday was yet another ugly day for bank stocks around the world, as the selling pressure continued following the SVB debacle in the US last week.  

The money flew into the safe havens. 

Treasury yields around the world tumbled sharply. The US 2-year yield tipped a toe below the 4% mark, from above the 5% level last week, after Federal Reserve (Fed) Chair Jerome Powell hinted at potentially faster rate hikes in the US to abate inflation.  

That expectation is no longer on the menu du jour.  

On the contrary, there is now a massive lack of consensus in the market regarding what the Fed should do, and what the Fed will do. Some think that if today’s inflation data is not sufficiently soft, the Fed should continue hiking by 50bp. Some others think that the Fed should simply hike by another 25bp this month and signal a pause starting from the next meeting – which would be the smoothest solution of all for the market. An increasing number of investors and bank analysts including Goldman Sachs believe that the Fed will skip the March rate hike. Others stretch the ‘no rate’ idea further and think that we will finally get the pause in the US rate hikes that many were hoping for as soon as this month – meaning that the rate hikes will be over for this cycle for the US. And there are some extreme opinions, like Nomura, which think that the Fed could cut by 25bp at next week’s meeting to contain the crisis in the banking sector.  

Now, in theory, the worst of the crisis should be behind us, as the US government guaranteed all depositors of the banks that collapsed last week. But the crisis will surely get the Fed to think twice about what to do at next week’s meeting.  

For now, the pricing on Fed funds futures suggests that there is slightly more than 70% chance of a 25bp hike next month, and slightly less than 30% chance for no rate hike.  

This is a big, big change since last week.  

How will the market react to US CPI? 

The US CPI data due today could reshuffle the Fed expectations regarding what will happen next week.  

Both headline and core inflation are expected to have eased in February, but investors are cautious given that last month’s disappointment could be repeated this month, as the base effect – where we will finally start comparing the war months to the war months won’t be in play until March – as Russia invaded Ukraine by end of February last year.  

Plus, Manheim’s used car index, that serves as an indicator of US inflation (though much less powerful than it used to be during the pandemic months) spiked significantly higher in February.  

Therefore, it could be another month of a challenging CPI read for the US.  

But the logic this time could be different than before last week. A CPI data in line, or ideally softer-than-expected could fuel the expectation of ‘no hike’ from the Fed this month, whereas a stronger-than-expected CPI figure may not fuel the expectation of a rate hike from the Fed, as many investors will be urging the Fed to stop hiking the interest rates and be patient about the impact on inflation that could come with delay.  

Volatility mounts but we are nowhere close to panic levels 

Turmoil in the market is also reflected through the spike in the volatility index. The VIX hit 30 level yesterday, the highest since October, but note that we are nowhere near the levels that were seen during the 2007/2008 subprime crisis, or the European debt crisis, or the pandemic selloff.  

The S&P500 gapped lower on Monday, gained, then gave back gains to close the session slightly in the negative, while Nasdaq 100 – which also gapped lower at the open - closed the session 0.79% higher as the technology stocks rallied on the back of tumbling rate hike expectations and tumbling yields as a result of it. 

 Apple for example gained 1.33%, while Microsoft rallied more than 2% yesterday. And indeed, a surprise pause in Fed’s rate tightening could further boost the tech stocks that are rate-sensitive, and that have been hammered by the higher rate expectations over the past year. 

Another asset that benefits from the sharp decline in risk appetite, and the sharp decline in US yields is gold. The price of an ounce rallied by more than $100 since last week, and hit $1914 per ounce yesterday. Yet, the rally will likely lose its power as soon as the calm returns to the market. A correction below the 50-DMA, around $1875, is likely in the next few sessions. 

What about the ECB’s 50bp hike? 

When the US sneezes, the world catches a cold. The tumbling rate hike expectations in the US are spreading through other parts of the world.  

Traders now see less than a 50% chance for another 50bp hike from the European Central Bank (ECB) this Thursday, and the expectation of the peak ECB rate fell below 3.5%, from around 4% last week.  

But despite the softening ECB expectations, the EURUSD flirted with 1.0750 yesterday, as the US dollar sank deeper across the board.  

And well, in periods of strong price action in the US dollar, the dollar is the main catalyzer of market pricing. Therefore, the ECB expectations could temper the FX moves, but could hardly reverse the direction of the market dictated by the USD.