CPI Heavyweight Report: After tonight, does the Federal Reserve no longer need to wait patiently?

On July 11th at 20:30, the United States will release the latest CPI inflation data. With Federal Reserve Chairman Powell attending hearings for two consecutive days and indicating that after further progress in inflation, the latest CPI will have a significant impact on the possibility of a rate cut in September.

After unexpected increases earlier this year for several consecutive months, CPI inflation seems to finally be moving in the right direction. PCE inflation has improved, but service sector inflation under both CPI and PCE indicators has remained high. Previously, in the context of a still tight labor market, the Fed's "higher" stance is not only reasonable, but there are even sufficient reasons to further raise rates in early 2024.

However, the Fed's patience may now pay off, not only with inflation pressures easing again, but increasing evidence suggests that the hot labor market is cooling down, with Fed Chairman Powell also stating that supply and demand have rebalanced. In the June non-farm payroll report, the unemployment rate rose to 4.1%, the highest level since November 2021, while the wage growth rate fell to just below 4.0%. Although the non-farm employment figure slightly exceeded expectations, the data for the previous two months was also revised downward by a total of about 110,000 people.

As the job market slows down in a more convincing manner, the Fed may have less reason to continue to be cautious and patient , if CPI inflation further slows down, it may tilt the balance more towards dovishness.

Wall Street Expectations

Wall Street generally expects that this week's CPI data will show a further decline in U.S. inflation, which may support multiple rate cuts by the Fed this year.

According to economists surveyed by Reuters, economists predict that the June CPI annual rate to be announced on Thursday night at 20:30 will be 3.1%, lower than May's 3.3%. However, core inflation, excluding the more volatile food and energy sectors, is expected to remain unchanged, with monthly and annual rates forecasted at 0.2% and 3.4%, respectively. This indicator is closely watched by rate setters, having dropped to a three-year low of 3.4% in May, but economists do not expect the upcoming data to make further progress.

In addition to these key data, the Fed will also closely monitor changes in service sector inflation. Specifically, the core service sector CPI index, excluding housing costs, has been accelerating growth throughout the year, increasing by 5.0% year-on-year in May. Ideally, the Fed hopes to see this specific indicator decline, possibly for at least two consecutive months, before relaxing vigilance on inflation. In addition to last Friday's non-farm data showing that the pace of hiring in the United States is slowing, the latest inflation data may support the Federal Reserve in implementing its first rate cut sooner. The current market expects two rate cuts this year, with the first one expected to come in September or November. However, Federal Reserve officials indicated at the June meeting that they expect only one rate cut this year. Even though all CPI sub-indexes declined in June, it may not be enough for the Federal Reserve to signal that the time for a rate cut has come. This rules out any policy shift at the July meeting, but the situation is different in September. After the release of this week's CPI data, there will be two more CPI and PCE inflation reports released in the United States before the September FOMC meeting, providing ample time for the Federal Reserve to cut rates in September.

Barclays economists led by Pooja Sriram wrote, "Following a series of strong inflation data in the first quarter, if June's inflation results align with our forecasts, it should strengthen the Federal Reserve's confidence that the process of inflation easing is underway."

"We believe that the tone of the (employment data from last Friday) is very important for assessing whether the conditions necessary to support the continued return of inflation to the 2% target are in place."

Since July last year, Federal Reserve officials have kept interest rates at their highest level in 23 years to curb borrowing and spending, and to bring down inflation from the four-year high reached in 2022. Recently, Federal Reserve policymakers have indicated that they will continue to closely monitor inflation data, looking for signs that prices are returning to the 2% target before considering a rate cut.

According to the CME Group's FedWatch tool, the financial markets expect a probability of over 75% for a rate cut at the Federal Reserve's September meeting.

Market Reaction Predictions

Andrew Tyler, head of U.S. market intelligence at J.P. Morgan's trading desk, stated that "the prices of straddle options expiring on Thursday indicate that the options market is betting on the S&P 500 index fluctuating by 0.9% before that day." The latest CPI data will be released before these options expire, which may prompt traders to bet that easing inflation will lead the Federal Reserve to cut rates twice in 2024.

It is forecasted that core CPI will rise by 0.2% month-on-month in June. Tyler believes that if the final reading exceeds 0.3%, it is likely to trigger a sell-off in risk assets, causing the S&P 500 index to fall by 1.25% to 2.5%. However, he believes that the probability of this scenario occurring is only 2.5%.

Furthermore, if the month-on-month growth rate of core CPI is between 0.15% and 0.20% (which J.P. Morgan's trading desk considers the most likely scenario), the S&P 500 index is expected to rise by 0.5% to 1%; if it is between 0.20% and 0.25%, the stock market may initially react negatively, but the eventual decline in bond yields will support the stock market, pushing the S&P 500 index up by 0.25% to 0.75% He added that any reading below 0.1% would be considered extremely favorable for the stock market, potentially triggering some calls for a rate cut in July, and causing the S&P 500 index to rebound by 1% to 1.75%.

Key Price Cooling, Consumers Stretched to the Limit

The expected significant decline in inflation data is largely due to prices of several key items in household budgets remaining stable or even decreasing.

Economists at Wells Fargo Securities wrote in their analysis that after seasonal adjustments, gasoline prices have fallen, and the rate of increase in grocery prices is expected to slow down. Several major retailers announcing promotions or price cuts have proven this point.

Economists at Deutsche Bank stated that forecasters believe core inflation will be more sticky, as prices of some key items may rebound from May, when these prices unexpectedly dropped, such as car insurance and airfares. Economists at Wells Fargo Securities mentioned that despite this, inflation may remain relatively moderate, with price increases expected to slow down by 2025.

One key reason is that consumers are already close to their limits in terms of what they are willing and able to pay, and businesses are aware of this. Previously, the Fed's Beige Book showed that shoppers worldwide have grown tired of high prices, leading many businesses unable to continue raising prices. Since 2021, household budgets have been stretched due to high inflation, and have now reached their limits in terms of what they are willing to spend on goods. Customer resistance has led businesses to offer discounts in an attempt to win back or retain customers. For example, fast-food chains like McDonald's and Burger King have been offering "value meals" promotions.

Economists Sarah House and Aubrey George wrote, "Softer consumer demand could dampen prices." "Consumers are increasingly cost-conscious, which could also limit the extent of price increases across the entire service sector."

Trading Logic of CPI

CPI tracks changes in prices of goods and services. It measures the changes in prices of a "basket" of goods and services, including food and beverages, energy, housing, transportation, medical care, entertainment, etc.

CPI data is important for traders and investors as it provides crucial information about inflation, which significantly impacts financial markets. Inflation affects consumer purchasing power and the value of money, directly impacting the demand and supply of goods and services.

Inflation also indirectly affects financial markets, as central banks typically use monetary policy tools (such as adjusting interest rates) to control inflation. If inflation rises too quickly, central banks may raise interest rates to curb inflation, leading to a decrease in consumer spending and economic growth, and negatively impacting financial markets On the contrary, if inflation is too low, the central bank may cut interest rates to encourage consumer spending and economic growth, which may have a positive impact on the financial markets.

Traders can use both overall and core CPI to assess the level of inflation in the economy and predict the future direction of interest rates. If overall CPI or core CPI accelerates upwards, it may indicate that inflation is becoming a problem, and traders may anticipate a rate hike by the central bank, which could have a negative impact on the financial markets. Conversely, if overall CPI or core CPI is low or decreasing, traders may anticipate the central bank to maintain or even cut interest rates, which could have a positive impact on the financial markets.

Generally, when overall CPI is below 1.5%, low inflation usually indicates economic recession or insufficient demand. Traders may consider bullish assets such as gold, silver, and strong currencies, while bearish on US stocks, stock indices, and the US dollar. During times of economic uncertainty and low inflation, precious metals typically perform well, currencies of countries with strong economic fundamentals may appreciate, and as interest rates fall, bond prices may rise. Additionally, due to reduced economic activity and declining corporate profits, the stock market may perform poorly. With rate cuts by the Federal Reserve, the US dollar may also weaken.

When CPI is between 1.6% and 3.5%, the Federal Reserve may lean towards maintaining stable interest rates or lowering rates from high levels. This range indicates healthy economic growth, and traders may consider being bullish on stocks, indices, non-dollar currencies, and bonds, while bearish on gold and the US dollar. In a moderately inflationary and stable economic environment, stocks typically perform well. Moreover, as investor attention shifts to high-yield assets, precious metals may underperform. If other currencies become more attractive, the US dollar may remain stable or depreciate.

When CPI is above 3.5%, the Federal Reserve may raise interest rates to cool down the economy. High inflation can lead to price instability, which can harm the economy. Traders may consider being bearish on the US dollar, stocks, indices, and non-dollar currencies, while bullish on gold and bonds. Precious metals are often seen as hedges against inflation. While short-term bonds may be affected, long-term bonds may still provide a hedge against inflation. Due to rising interest rates and increased input costs, stocks may face negative impacts.

The above scenarios are theoretical deductions, and the actual market performance may deviate from theory because the price movements of financial assets are often influenced by multiple factors simultaneously. For example, in the current cycle of high inflation and rapid rate hikes by the Federal Reserve, the US dollar, gold, and US stocks have all performed well, and assets that used to show counter-trend movements have also exhibited "strange trends" of moving in the same direction