US Inflation Preview: Spark meets powder keg - 3 scenarios

• After wages finally caught up with employment and growth, only higher inflation is missing, raising the expectations for this report.
• Elevated market volatility and the sensitivity to rate hikes promise a robust reaction to the outcome.
• The three scenarios include the currencies likely to move most in each case

Why this inflation report is so important

Everything is looking bright in the US economy: job growth is strong and steady, growth is picking up, and most recently, wages seem to have found a sustainable upward trajectory.

In addition, the substantial tax cuts raise prospects for a leg up growth. Most recently, Congress has added more fuel to the fire by agreeing on additional spending. It was easier reaching a compromise when everyone is happy, except for deficit hawks. The US government is stimulating the economy when the economy is already quite hot and warming up on its own.

And if the economy overheats, we may see higher inflation and consequently higher interest rates. The Federal Reserve may raise rates more than three times this year and perhaps also increase the final rate in this cycle. These fears have led to the recent market falls as stocks are undergoing a revaluation. 

But so far, inflation has been the missing piece in the story: it has not been following the textbooks and has not increased the economy as expected. Former Fed Chair Janet Yellen once described it as a "mystery," and many other economists are puzzled as well.

Now we get the first inflation report for 2018 when wages were rising at a faster pace. Are prices finally moving higher? This has become a more important question after the recent jitters.

The CPI report is released alongside the retail sales one. Not that long ago, the retail sales numbers overshadowed the inflation ones. Core retail sales competed with the control group for dominating the market move, leaving core CPI behind. Yet things have changed in recent months and especially since the beginning of February.

This inflation report may have a more significant impact than the Non-Farm Payrolls. 

Core CPI at 1.8% is the magic number

The Fed watches core inflation and disregards headline numbers which include the volatile energy and food prices. They target the Core PCE and not the Core CPI, but the Core CPE is published only at the end of the month, and the changes go hand in hand with the CPI report.

Core CPI was around 1.7% year over year during most of 2017 and then moved to 1.8%, which was the level in the previous report. Expectations for January are for a repeat: 1.8%. This makes the reaction quite straightforward.

Month over month, Core CPI is expected to rise by 0.3%, exactly like in December. Headline CPI is projected to see a repeat of 2.1% y/y. The focus is on Core CPI y/y.

Here are three scenarios:

1) Core CPI above 1.8% - Stocks crash, USD, JPY jump

A pickup of inflation implies higher interest rates, thus boosting the US dollar against most currencies. 1.9% will trigger a significant move. Reaching the "holy grail" of 2% may result in a more prominent move. 

Which currencies could suffer most?

• The GBP/USD may be more vulnerable than others. A hawkish twist by the BOE triggered a rise in the pound, but it was short-lived. Worries about Brexit and May's upcoming speech add to its vulnerability.
• The USD/CAD may shoot higher: The Canadian dollar has been struggling with a weak jobs report, falling oil prices and concerns that NAFTA talks could break up.

The exceptions are the yen and to a lesser extent, the Swiss franc. An acceleration in price rises will likely result in a sell-off of stocks in the US and all over the world. The risk-off sentiment triggers safe-haven flows into these currencies, and we have seen that just now. Also, economic theories will benefit from a confirmation that the models still work.

2) Core CPI under 1.8% - Party in the USA, but not for the US dollar

A disappointing inflation report will upset economic theories but will be a boon to stocks. If inflation is still low, there is no rush to raise rates at a faster pace. The lower it falls, the more significant the impact.  Markets may begin betting on a "Powell Put." In this case, the dollar will be sold off all over, with the previous two exceptions: The USD/JPY and the USD/CHF are set to rise.

Which currencies could move most in this scenario?

• The EUR/USD could resume its uptrend: The pair remains in an uptrend trajectory, the euro-zone economies are looking good, and the ECB is on course to remove stimulus.
• The NZD/USD has room to the upside: The New Zealand economy is on a positive trend, and the quarterly jobs report was excellent. The Aussie may ride higher as well, but the Australian jobs report which is due shortly thereafter may keep traders cautious. 

3) Core CPI precisely at 1.8% - A mess on many moving parts

An "as expected" outcome on the primary indicator leaves room for the other numbers to stand out. A surprise on the monthly CPI may have the upper hand with markets ignoring the revisions. For example, a monthly CPI of 0.2% instead of 0.3% and despite an upwards revision could be detrimental for the dollar. A monthly rise of 0.4% with a downward revision could boost the dollar. 

The next factor to watch is headline CPI, and then the retail sales figures will have their say. However, the reactions may not be that outstanding if the most crucial number does not provide any shocks. 

The USD/JPY will probably best reflect the reaction. A rise in the pair implies a positive outcome for stocks and a negative one for the greenback against other currencies. A slide suggests an adverse issue for shares and a rise for the dollar against other currencies. The franc may follow the yen, but traditionally, USD/JPY has seen the best reaction to US events.

Lasting impact

In case we get a significant surprise in either direction, the effect may last for quite a while. Wall Street opens an hour after the publication, but the impact may continue through the end of the week or beyond. As aforementioned, this is a significant event. 

More: U.S inflation will determine whether recent price action is corrective or a reversal