It’s been an ongoing theme for the past weeks, this “fight” between the Federal Reserve and the markets.
Jay Powell and the rest of the Fed members (with the notable exception of Vice Chair Brainard) have been consistently hawkish in their rhetoric. They remind us – almost on every occasion – that high inflation is a real & serious problem, and that they are committed to bringing it down. They have also indicated that when inflation does recede enough for their monetary policy to go back to neutral, they will likely stay at that terminal fed funds rate for a decent amount of time, noting that the market’s prediction of rate cuts within 2023 is unrealistic.
In light of all this hawkish Fed talk, the market remains defiant and simply doesn’t seem to believe what the Federal Reserve members are telling us. The implied forward rate from the Fed Fund Futures strip peaks just below 5% in mid-2023, and then it prices two full 25bp cuts by January 2024 (and more thereafter):
As a result of these rate expectations by the markets, bonds and equities remain well bid and any dips continue to be bought, frustrating bears.
Where does this leave us ahead of Thursday’s US CPI print? First of all, we need to point out that these inflation readings are now arguably the most important of all economic data releases. It was spiking inflation that caused the Fed to hike hard and fast, and it will be falling inflation that will cause it to stop. Granted, employment data has been solid so far, but this part of the Fed’s dual mandate has admittedly moved out of focus and into the background.
Thursday’s YoY CPI is expected to drop from 7.1% to 6.5%, and the YoY Core CPI is expected to fall less, from 6.0% down to 5.7%. The recent trend in most major economies has been that of inflation missing to the downside – and there’s good reason to expect the same from the US numbers. This is the most likely scenario, but we need to make an important note: if CPI surprises to the upside, the magnitude and force of the move is likely going to be a lot bigger than if it surprises to the downside.
Yields have been the driving force for markets in the past year or so, and they will most likely continue to do so. The 10y UST yield is currently sitting at around 3.55% and a weak print could take it towards the confluence of supports that resides between 3.40% and 3.42%. Conversely, on a hot inflation print – depending on the magnitude of the upside surprise – we could reach the 3.91% year-end highs and if that resistance breaks, we could well challenge the October 2022 major high above 4.30%.
It’s a similar story for stocks. A weak CPI print would likely cause the S&P500 index to rally, but we seem to have already rallied a lot in anticipation of such a low CPI scenario. Also, the upside is likely capped – at least in the short term – by the confluence of resistances at around the 4000 mark. On a strong CPI print, the first support level lies at around 3800 points and then we have a major zone between 3560 and 3590.
To summarise, this fight between the markets and the Fed is currently being “won” by the markets. Only a strong inflation print (and preferably a string of them) could firmly tilt the balance on the Fed’s side. The most likely scenario is that inflation does indeed recede to lower levels, but it’s very important to understand that the potential market move is probably going to be a lot stronger if high inflation persists.
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