The "long vs. short" showdown in the US stock market reaches a climax! CPI collides with the Federal Reserve interest rate decision, intense volatility is brewing

According to the financial news app Smart Finance, from JPMorgan to Citigroup Inc., the trading departments of the most well-known commercial banks on Wall Street are urging investors to prepare for the sharp fluctuations in the US stock market this week. After investors experienced relatively calm trading days in the stock market recently, a huge wave of volatility is expected to emerge this week. The latest US CPI inflation data and the latest interest rate decision by the Federal Reserve will be announced on Wednesday Eastern Time this week. JPMorgan's trading department has outlined the potential market fluctuations after the release of inflation data; Citigroup's trading department expects a sharp increase in implied volatility due to CPI and the Federal Reserve interest rate decision.

Andrew Tyler, the head of market intelligence for the US market at JPMorgan's trading department, stated that the US stock options market is betting that the S&P 500 index is expected to fluctuate by 1.3% to 1.4% in both directions before Friday. This expected volatility is based on the price of at-the-money straddle options expiring that day, reflecting an unusually intense market battle between long and short positions. The majority of these volatility levels are expected to occur after the release of the Consumer Price Index (CPI) data report on Wednesday morning Eastern Time (Wednesday night Beijing Time) and the Federal Reserve's policy rate decision on Wednesday afternoon Eastern Time (early Thursday morning Beijing Time).

In a report to clients on Monday, Tyler and his trading team wrote: "Due to the simultaneous release of CPI and the Federal Reserve interest rate decision, the latest Federal Reserve dot plot, as well as Chairman Powell's remarks at the press conference, may reverse the market volatility presented by CPI."

The "at-the-money straddle options expiring that day" is an options trading strategy where a trader simultaneously buys a call option and a put option, both with the same strike price, which is often close to the current market spot price of the underlying asset. Statistics from JPMorgan's trading department show that the latest at-the-money straddle option prices largely reflect a high level of uncertainty and expected volatility in the upcoming economic data and interest rate dot plot, leading to an unusually intense battle between long and short positions.

This strategy is typically used by traders expecting significant market price fluctuations but uncertain about the direction of the movement. This setup ensures that at least one option contract can generate high returns when there is a significant change in the spot price. If the underlying price rises significantly, the purchased call option will yield profits; if the price drops significantly, the purchased put option will yield profits. While this strategy can be profitable in times of large market price swings, investors will incur losses in option premiums if prices remain relatively stable.

JPMorgan's Outlook on "CPI Release Day" - US Stock Market Trend Could Rise by up to 2.50% in the Most Optimistic Scenario

The economists compiled by the institution expect data to show that the overall CPI, including food and energy prices, is expected to increase by 3.4% year-on-year, which is roughly the same as in April. The overall CPI is expected to rise by 0.1% month-on-month, lower than April's 0.3%. Excluding the volatile food and energy prices, the "core CPI" is expected to increase by 3.5% year-on-year, lower than the 3.6% increase in April; economists expect the month-on-month increase in core CPI to reach 0.3%, roughly the same as the previous month.

This data will be released a few hours before the Federal Reserve announces its latest interest rate policy decision. The market generally expects that the Fed will maintain the benchmark interest rate at its highest level in 20 years at this meeting. The main focus of the market is on the Fed's latest Summary of Economic Projections (SEP), especially on the interest rate "dot plot" provided by Fed officials and comments from Fed Chairman Powell. The "dot plot" shows the policymakers' consensus expectations for future interest rate trends.

Considering all possible scenarios, the trading team at Morgan Stanley expects that the US stock market may experience sharp two-way fluctuations on the "CPI release day + Fed interest rate decision day", and global stock markets are likely to follow a similar trading pattern as the US stock market on that day.

According to Morgan Stanley's trading team, the most likely scenario on the "CPI release day" is that the month-on-month increase in core CPI will be in the range of 0.3% to 0.35%, with a probability as high as 40%. In this case, the S&P 500 index may fluctuate between a 0.75% decline and a 0.75% increase; the second-highest probability scenario is in the range of 0.25% to 0.3%, with a probability as high as 25%, where the S&P 500 index may fluctuate between a 0.75% increase and a 1.25% increase.

In the view of Morgan Stanley's trading team, the most optimistic expected range for the S&P 500 index is 1.75% to 2.50%, but this is the lowest probability scenario, only 2.5%, requiring a month-on-month increase in core CPI of only 0.2%; the most pessimistic expected decline range for the S&P 500 index is a decline of 1.5% to 2.5%, which is the second-lowest probability scenario, only 5%, requiring a month-on-month increase in core CPI of over 4%.

Morgan Stanley devises strategies on the "CPI release day" - the scenario analysis provided by the trading department of this commercial bank for the US stock market

Core CPI month-on-month range falls between 0.20% and 0.25%, expected to stimulate rapid rise in September rate cut expectations

Taylor emphasized that if the core CPI in the United States in May increases by more than 0.4% month-on-month, it may trigger short-term selling of risky assets such as stocks, with the S&P 500 index expected to fall by 1.5% to 2.5%. However, he believes that the probability of this scenario is only 5%.

Core CPI excludes the volatile components of food and energy, and is considered a better potential measure of inflation than the overall CPI index. Economists generally expect the core CPI in May to rise by 0.3% compared to the previous month.

Taylor wrote that if the core CPI is between 0.3% and 0.35% month-on-month - which is the most likely scenario predicted by JPMorgan's trading department - the final movement of the S&P 500 index will fluctuate between a decrease of 0.75% and an increase of 0.75%. Taylor stated that this will depend on the "anti-inflation" progress of U.S. housing prices, as well as the upward trends in car and medical prices.

Taylor also emphasized that if the core CPI is only between 0.20% and 0.25% month-on-month, then the market expectations for a rate cut by the Federal Reserve in September may rapidly soar, and the U.S. stock market will start a new round of rally. He explained that after the European Central Bank implemented its first rate cut in 5 years last week, some traders even bet that a rate cut by the Federal Reserve in July would be the market's "unexpected insurance".

It is worth noting that after the surge in U.S. non-farm payrolls in May and the announcement of wage growth exceeding expectations last Friday, traders significantly postponed the potential timetable for a Federal Reserve rate cut when the relevant data was announced last week. Following the far better-than-expected non-farm payroll data released last Friday, the market's expectations for a Federal Reserve rate cut cooled significantly, with the current interest rate futures market only betting on a rate cut by the Federal Reserve in December, and the complete retreat of rate cut expectations for September before the non-farm payroll announcement.

A report released by Bank of America last week pointed out that for bullish investors in U.S. stocks, the "appropriate range" for May non-farm payroll additions is between 125,000 and 175,000 (the actual data released last Friday was 272,000). If this goal is achieved, the U.S. stock market may see a rebound, and if it falls below or exceeds this range, it will trigger a sell-off.

Taylor from JPMorgan also added that any inflation data below 0.2% month-on-month will be seen as a significant positive for the U.S. stock market, leading to a rebound of 1.75% to 2.50% in the S&P 500 index.Meanwhile, Stuart Kaiser, the head of US stock trading strategy at Citigroup, suggested that investors should prepare for stock market volatility on the day of the Federal Reserve interest rate decision. The trading strategy chief expects this to be the largest US stock market volatility since March 2023.

As the possibility of significant stock market volatility surrounding the CPI report and the Federal Reserve interest rate decision arises, volatility indicators in the market have been historically suppressed. The Chicago Board Options Exchange (Cboe) Volatility Index (VIX) is currently near a 52-week low, at 13, significantly below the level of 20 that typically triggers concerns among options traders