- Markets went from the expected response to the higher inflation report to the other direction.
- The sharp turnaround is related to the data but also to another factor.
The inflation report for January has been creating high tension for several days and has received heightened media attention. The high expectations were met: markets rocked and rolled on Valentine's Day, and the broken heart of equity bulls and dollar bears was healed.
Initially, everything went as expected: a higher inflation report meant a quicker pace of interest rate rises. This was reflected in a surge in expectations for four hikes in 2018: 23% against 17% according to the CME Group's Fed Watch tool. The markets' reaction was also in line with expectations: a higher dollar in anticipation for higher rates and a significant drop in stock futures in that same expectations.
But then things turned around sharply: stocks opened with shallow falls which later turned into rises. The dollar that initially soared saw a massive sell-off.
So what is behind this Valentine Volatility?
- Inflation is not so high: Core inflation remained at 1.8%, higher than 1.7% that was expected but not above levels seen in previous months. In addition, core CPI remains under 2%, the holy grail for central bankers. Headline inflation rose to 2.1% y/y, above that level, but we had already seen levels above 2% in 2017. So, investors may have had second thoughts about how high inflation is.
- Retail sales badly disappointed: The US economy is centered around consumption. Not that long ago, retail sales overshadowed the inflation report. This time was different, but mostly in the initial response. Headline sales dropped by 0.3%, and the control group remained flat. Both figures came out below expectations. Moreover, the report for January also included downward revisions for December. The weak report triggered a downgrade of GDP forecasts by the Atlanta Fed's Nowcast measure and also by commercial banks. If growth is not that strong, perhaps the Fed is in less of a hurry to raise rates? This thought also helped alleviate pressures from markets.
- VIX vertigo: The last painkiller for markets came from the volatility index. The VIX and its derivatives went wild on February 5th and exacerbated the market sell-off. The fall of the VIX below 20, implying calmer days ahead, also contributed to the better market mood allowing stock bulls to run and dollar bears to hug each other on Valentine's Day.
Will the stock rally and the dollar sell-off continue? It is hard to tell. While the VIX is down, volatility in foreign exchange markets is undoubtedly higher. Also, US bond yields did follow the initial and expected reaction, and they have reached new 4-year highs, still implying higher rates.
All in all, currencies are still experiencing high volatility, so it is important to trade with care.
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