U.S. CPI released on Wednesday! Inflation takes the "C position" from employment, traders bet on "CPI day" for less volatility in U.S. stocks

Since the Federal Reserve began actively combating inflation two years ago, the monthly release of US CPI data has attracted high market attention. However, the situation should be different when the latest CPI data is released on Wednesday.

Why?

Because as the inflation rate trends down towards the Fed's target, the Fed will lean its policy target towards the labor market in preparation for rate cuts, making inflation data less important for US stocks. Instead, everything is related to the weakness in the job market and whether the Fed can avoid a hard landing.

Eric Diton, President and CEO of Wealth Alliance, said: "The key issue facing stock market investors is whether the Fed waited too long to cut rates, as the risk of recession is now higher than two months ago. Suddenly, inflation is no longer a big issue."

The S&P 500 just had its worst week since the collapse of Silicon Valley Bank in March 2023, with large tech stocks falling and Nvidia (NVDA.US) dropping by 14%. Volatility has also increased, with the Chicago Board Options Exchange Volatility Index (VIX) rising from 15 on August 30 to nearly 24 on September 6.

Options traders are betting that this data will rise but remain below the market's volatility expectations on the day of the CPI release. As of last Friday morning, they expected the S&P 500 to fluctuate up and down by 0.85% on Wednesday. According to data compiled by Piper Sandler, if this target is achieved, it will be the smallest increase on a CPI release day this year.

On the other hand, ahead of the weak employment report released last Friday, traders expected the implied volatility of the S&P 500 to reach 1.1%. According to data compiled by Susquehanna International Group, this is one of the highest absolute levels this year, 83% higher than the average implied daily volatility in 2024. The market index fell by 1.7% that day, exceeding expectations.

Fed Rate Cut Imminent, Market Focus Shifts to Jobs Data

Basically, the market's thinking has now shifted, with a Fed rate cut seen as inevitable, but the extent of the rate cut is not so clear.

On August 23, Fed Chair Powell almost declared victory in the fight against inflation at the central bank symposium in Jackson Hole. Since then, more policymakers such as New York Fed President Williams, Chicago Fed President Evans, and Fed Governor Waller have indicated the need for rate cuts - the question is the extent of the rate cut.

Now, the Fed is turning to the other side of its dual mandate, which is maintaining maximum employment. According to data from the US Bureau of Labor Statistics, the employment report released last Friday showed an increase of 142,000 non-farm jobs last month, bringing the three-month average to its lowest level since mid-2020 Looking ahead to the Federal Reserve's interest rate decision on September 18, the forward contracts fully reflect expectations of at least a 25 basis point rate cut. At the same time, data compiled by UBS shows that implied volatility is accelerating before major macro events related to employment, with stock market volatility indicators (such as the skew index) remaining high as traders hedge against further downside risks in the stock market.

Rocky Fishman, founder of derivatives analysis company Asym 500, said: "Skew indicates that there is additional value in providing downside protection for hedging. If the results are indeed disappointing from a macro perspective, the potential downside of the stock market this time may be greater than previously imagined."

Currently, investors have ample reason to be more cautious about employment data compared to inflation data. The S&P 500 index recorded its worst day for employment data release since 2022 last month, falling 1.8% on August 2 (Friday) and dropping another 3% on August 5 due to weak employment reports. Two weeks later, inflation data was largely in line with expectations, and the S&P 500 index only rose by 0.4%, marking the smallest single-day increase in CPI since January.

Increased Risks in US Stocks

UBS data shows that traders expect an increase in volatility in the S&P 500 index, as demand for out-of-the-money put options exceeds that for out-of-the-money call options. UBS stated that Commodity Trading Advisors (CTAs) in the futures market manage asset price trends through long and short bets, and they believe there is hardly any room to add positions now.

The volatility index of the benchmark US stock index futures implied by over-the-counter options, the VIX, is currently in the low 20s, which does not necessarily indicate danger. However, this level is 52% higher than the average level this year, and the volatility curve suggests that risks will rise in the coming months.

As Federal Reserve officials are in a blackout period before the next policy decision, they will not make any comments before September 18. However, the latest Beige Book from the Federal Reserve shows that compared to inflation, business contacts are more concerned about slowing economic growth. The Beige Book compiles information from business contacts in the Federal Reserve's 12 districts. However, the report does not mention "economic recession," mentioning "inflation" only 10 times - the lowest level in 2024 according to DataTrek Research While the general expectation is for the U.S. economy to remain strong, the GDPNow model from the Atlanta Fed is showing some signs of slowing down, with the projected real GDP annual growth rate for the third quarter at 2.1%, lower than the approximately 3% a few weeks ago. This is just another signal that the Federal Reserve may need to cut interest rates before it's too late to prevent an economic downturn. If they don't do so, investors who have been driving up the stock market in anticipation of policymakers quickly lowering borrowing costs may have to consider the old saying: "Be careful what you wish for."

Diton from Wealth Alliance stated that if the stock market intensifies its concerns about the Federal Reserve's inadequate response to economic slowdown, the situation will be particularly critical; economic slowdown will eventually impact corporate profits. He said, "Everyone is now watching every data point on the economy and employment. If it continues to weaken, there will be more selling."