Will July CPI completely trigger rate cut expectations? Tonight is bound to be very exciting!

The overnight release of the US July PPI showed a comprehensive unexpected decline, with service costs falling for the first time this year, proving that the inflation situation has reversed, leading to an increase in market expectations for a Fed rate cut; tonight, the second heavyweight inflation data of the week, the July CPI, is set to be released, with the market generally expecting that if inflation continues to show signs of slowing down, the Fed may adopt a more accommodative monetary policy stance.

Wall Street generally expects that in July, the core CPI (excluding volatile food and energy prices) is expected to decrease by 0.1 percentage points to 3.2% year-on-year compared to June, potentially hitting the lowest level since May 2021; the month-on-month increase may rebound from 0.1% in the previous month to 0.2%.

The overall CPI year-on-year increase is expected to remain at 3%, the lowest level since June 2023; with a 0.2% increase month-on-month, compared to a 0.1% decrease in June.

Additionally, as a reference, the Cleveland Fed's inflation forecast shows that overall inflation is expected to increase by 0.24% month-on-month in July, with a 3.01% year-on-year growth; core inflation is expected to rise by 0.27% month-on-month, with a 3.33% year-on-year growth, posing an upside risk relative to Wall Street's general expectations.

Although the inflation rate remains above the Fed's 2% target, inflationary pressures have significantly eased. Jim Baird, Chief Investment Officer at Plante Moran Financial Advisors, stated, "Inflation is hardly a concern at this point. People generally believe the worst is over."

Like other Wall Street figures, Baird expects the Fed to shift its focus to a more accommodative policy in September to prevent labor market deterioration. The CME FedWatch Tool shows that the probability of a 50 basis point rate cut in September has increased from 50% to 53%, surpassing the probability of a 25 basis point cut, with the Fed's rate cut expectations for the year rising from 103 basis points to 108 basis points.

Used car and new car prices in July may continue to fall, while OER sees moderate increase

Bank of America believes that due to the rise in core service inflation and energy prices, the overall inflation rate increased by 0.25% month-on-month, with the year-on-year increase remaining unchanged at 3.0%; core CPI increased by 0.22% month-on-month, stating "although this number is not as low as in June, it is consistent with the previous deflation trend and should meet the benchmark for the Fed to start cutting rates in September."

Regarding core service inflation, Bank of America pointed out that due to the decrease in airfare prices, core service rents and owner's equivalent rent (OER) slightly decreased in June, but it is expected that the decline in airfare prices in July will be much smaller. The bank also noted that housing prices are expected to rise, but the decline in rents and OER is expected to remain unchanged.

If the CPI report in July meets our expectations, we still expect the Fed to start a rate cut cycle in September, with a projected rate cut of 50 basis points by the end of the year.

Goldman Sachs' forecast is more dovish, expecting an overall CPI increase of 0.17% month-on-month, and a core CPI increase of 0.16%, both below consensus expectations. Here are the trends of the four key components of CPI as forecasted by Goldman Sachs:

In July, prices of used cars and new cars continued to decline, with month-on-month decreases of 1.5% and 0.1% respectively. The auction prices of used cars have already dropped by 26% from their peak, while CPI used car prices have fallen by 18%, indicating further room for decline in the CPI index.

Airfare prices are expected to decrease by 2.5% month-on-month, which could be another significant drop since June, reflecting sustained resistance from seasonal fluctuations.

OER is expected to increase by 0.29% month-on-month, with a mild upward trend. Goldman Sachs believes that strong growth in single-family residential rents may cause OER to outpace rents in the CPI, with banks expecting overall housing inflation to run at a rate of around 0.25-0.30% per month by the end of this year.

Car insurance prices will rise, but not as quickly as earlier this year: It is expected that car insurance will increase by 0.7% month-on-month, compared to an average increase of 1.2% so far this year.

How will the market react?

July's PPI slowed down across the board, raising expectations of a Fed rate cut, leading to a broad overnight rally in U.S. stocks, with the Nasdaq rising by over 2%, and the S&P 500 and Dow both closing up by over 1%. So, how much of a splash will tonight's CPI announcement make in the market?

Last week, U.S. stocks experienced intense volatility, with the Cboe Volatility Index (VIX) measuring the magnitude of S&P 500 fluctuations reaching levels not seen since the peak of the 2020 pandemic. According to a Citigroup report, traders expect at least a 1.2% volatility in the S&P 500 when the CPI report is released.

According to Goldman Sachs trader Lee Coppersmith's forecast, if the core CPI increases by 0.19%-0.24% month-on-month, meeting or slightly exceeding market expectations, the S&P 500 index may fluctuate by 0.4%, but if it falls slightly below market expectations, the S&P 500 index is expected to see a stronger rally.

It is worth noting that CPI has been below market expectations for three consecutive months, whether tonight's CPI will continue to be below expectations, driving the stock market to continue its rebound, or will become the first "better-than-expected" report since March, dampening market enthusiasm.

Goldman Sachs pointed out that the implied volatility of straddle options on Wednesday is expected to reach 1.0%, a significant increase from last month's 0.65%, and it is the highest implied volatility change in the past year. With the VIX trading price around 20, this is foreseeable.

Regarding market reactions, fund flow strategist Scott Rubner stated:

I believe that the stock market's downside risk reflected by tomorrow's (Wednesday) CPI price is greater than the upside potential, and today we estimated the low point after PPI in the market. However, every macro data from now on will be used as a volatility clearing event.

My capital flow framework will shift to the buy side next week, and systematic supply pressure will ease. By the end of this week, CTA selling behavior will completely disappear, making the competition fairer.

Macro EQ Vol trader Shawn Tuteja commented:

I believe that the impact of CPI on US stocks is becoming less significant, and the volatility market seems to agree with this view. The narrative has now completely shifted to whether the economic slowdown is faster than the Fed's reaction speed (i.e., whether the Fed is already behind the curve?), so we are more focused on retail data (to be released on Thursday) rather than this month's CPI