Betting on inflation cooling down! US stocks and bonds rise together, "racing ahead" of tonight's CPI?

Before the CPI is announced tonight, the market's confidence in cooling inflation has strengthened. The comprehensive lower-than-expected release of the US July PPI on Tuesday, with service costs declining for the first time this year, proves that the inflation situation has reversed. Subsequently, the market's expectations for a Fed rate cut have increased; boosted by this news, US stocks and bonds rose together, with US stocks closing at daily highs and bonds rising across the board.

At the same time, the financial markets indicate that the possibility of an impending economic recession is increasing. Although the probability of a US economic recession is still relatively low at present, Goldman Sachs and Morgan Stanley's models show that based on signals from the US bond market and the performance of stocks that are sensitive to business cycles to a lesser extent, the market's implied probability of an economic recession has significantly increased.

Goldman Sachs data shows that the current probability of a US economic recession as perceived by the stock and bond markets is 41%, higher than the 29% in April. The recent significant rise in the stock market is due to market bets that the Fed will take a more aggressive rate cut stance, while the performance of stocks sensitive to business cycles lags behind. A similar model by Morgan Stanley calculates that due to significant repricing of US Treasury bonds, this probability has jumped from 20% at the end of March to 31%.

The likelihood of a recession reflected in the interest rate market is higher than that in the stock market according to Goldman Sachs and Morgan Stanley's models. Goldman Sachs' model shows that the 12-month forward change in the Fed's benchmark interest rate implies a 92% chance of an economic recession next year, while Morgan Stanley's model shows that the change in the five-year US Treasury bond yield indicates a 58% chance of an economic slowdown.

Therefore, the market has fully priced in a 25 basis point rate cut by the Fed in September, while the probability of a 50 basis point rate cut in September is estimated at 52.5%. Bond traders who have recently experienced severe market volatility are betting that the bond market will see a significant rise after the release of the US July CPI data on Wednesday.

Matt Luzzetti, Chief US Economist at Deutsche Bank, said after the PPI release on Tuesday: "The market is leaning very gently and expects soft inflation data, which will allow the Fed to start cutting rates." Zhitong Finance learned that in the past two trading days, the number of open positions in some term contracts (i.e. the risk exposure of futures traders) has started to rise, which is consistent with the emergence of new long positions in the U.S. Treasury yield curve after a period of aggressive liquidation. Meanwhile, in the spot market, a client survey on U.S. bonds released by JP Morgan on Tuesday showed that clients' net long positions have reached the highest level since December last year.

In the U.S. Treasury options market, similar to the futures market, traders have retreated from the extreme market conditions, although the positioning indicates that the expectation for a decline in U.S. bond yields has not changed. According to the so-called option skew, traders are betting that the bond market is more likely to see a larger rebound in the next few days rather than a decline.

Citigroup strategist David Bieber stated that even after traders unwound some extreme bullish positions, the market sentiment remains firm, "remaining long on bonds tactically and structurally."

U.S. CPI Preview for July

The U.S. Bureau of Labor Statistics will release the U.S. CPI for July at 20:30 Beijing time on Wednesday. The data to be released by the U.S. Bureau of Labor Statistics may show a moderate increase in inflation last month, reinforcing the widespread expectation of a rate cut by the Federal Reserve in September. According to surveys, economists generally expect the overall CPI and the "core" CPI excluding food and energy to rise by 0.2% month-on-month in July. This will be the smallest three-month increase in core inflation since early 2021—when the widespread rollout of COVID-19 vaccines stimulated the U.S. economy's recovery.

Anna Wong, Chief U.S. Economist, stated in the data preview: "Bloomberg Economics expects that driven by the slowdown in long-term expectations for housing rents, the decline in prices of used cars, and the drop in prices of discretionary services due to consumer spending control, the CPI for July will soften."

Here are the key components worth paying attention to in the report:

Rent

By the end of 2023, core inflation excluding housing had basically returned to pre-pandemic levels. However, CPI data shows that rapid growth in rents has been ongoing for most of the first half of 2024. Nevertheless, in June, they sharply decelerated, marking the smallest monthly increase since mid-2021 Economists expect that the slowdown trend in the coming months will continue, helping to curb the overall increase in CPI. Rent is the largest category in this index, so they have a huge impact on determining the overall trend.

Economists Sarah House and Aubrey George from Wells Fargo Bank stated in their data preview on August 7th: "Based on the new tenant rent index from the Bureau of Labor Statistics and the vacancy rate in the private sector, the decline in major housing in June looks sustainable. We expect a further increase of 0.3% in July, and by the end of this year, major housing prices will rise by 0.25%-0.30% per month."

Used Car Prices

Analysts are still particularly focused on used cars in the commodity sub-items of the CPI. Considering the weight of core commodities in this index, the decline in July may help continue the overall decline in the core commodity basket. In the past 13 months, the core commodity basket has seen declines in 12 months.

Although a widely tracked used car wholesale price index released by Manheim rose in July, the CPI index tends to lag behind, and July saw the first increase since January.

Goldman Sachs economists Ronnie Walker and Jessica Rindels stated in their data preview on August 12th: "Used car auction prices have now fallen 26% from their peak, while used car CPI prices have fallen 18%, indicating that there is further room for the CPI index to fall."

In addition, Goldman analysts stated: "We expect new car prices to decrease slightly, as dealer promotional incentives rebound after the end of disruptions in dealer software systems in June."

Airfare Prices

In the June report, airfare prices were a significant factor in the unexpected decline in the core CPI index, with a 5% drop being the largest in a year. This helped the index measuring core service costs excluding rent to see consecutive monthly declines for the first time since mid-2021.

Citigroup economists Veronica Clark and Andrew Hollenhorst stated that the data for July is a source of uncertainty, with reasons for both increases and decreases. Citigroup economists wrote in their report preview on August 12th: "We were surprised by the weakness in airfare prices last year, and after seasonal adjustments, airfare prices are even lower than pre-pandemic levels. We have been expecting airfare prices to rebound this year, as flight samples priced by CPI last summer may have reflected flights with lower summer demand. However, due to generally weaker travel demand compared to last year, airfare prices may continue to be weak."