Shivering! The US CPI is coming on Wednesday, and the US stock market may face a new storm

According to the Smart Finance app, the United States will release the highly anticipated Consumer Price Index (CPI) report for July this Wednesday. Traders hope that this report will provide the necessary ammunition for the Federal Reserve to start cutting interest rates at the September meeting. However, it is expected that market volatility will further intensify.

Last week, the Chicago Board Options Exchange Volatility Index (VIX), which measures the price fluctuations of the S&P 500 Index, reached its highest level since the peak of the 2020 pandemic. Citigroup stated that based on the cost of put and call options at parity, traders expect the S&P 500 Index to fluctuate by 1.2% on Wednesday when the U.S. CPI is announced.

If this pricing remains unchanged by the close of trading on Tuesday, it will be consistent with the implied trends on August 23 (Federal Reserve Chairman Powell's speech at the Jackson Hole meeting) and August 29 (the day after NVIDIA's earnings report).

Rocky Fishman, the founder of derivatives analysis company Asym 500, stated, "The options market has not yet sent a signal to the stock market to lift the alarm. Historically, when volatility is high, it is a good time to buy stocks, to some extent, this has already happened, so the CPI will be an important catalyst."

Furthermore, despite the S&P 500 Index rebounding from a 3% drop last Monday and closing flat last week, options professionals are not entirely convinced of this recovery. The stock market's sharp decline last Monday coincided with a massive unwinding of yen-driven arbitrage trades, disrupting the global bond market.

Expensive Insurance

Data compiled by Bloomberg shows that the cost of contracts to hedge against a 10% decline in the SPDR S&P 500 ETF (SPY) in the next 30 days is at its highest level since October last year, double the cost of contracts to hedge against a 10% increase.

Rising costs to hedge against a decline in the S&P 500 Index

Powell may soon formulate a plan to lower interest rates. Powell hinted at the end of July that the Federal Reserve could cut borrowing costs as early as September, and the information he releases later this month may help investors predict how many rate cuts there will be next year.

Thomas Urano, Co-Chief Investment Officer and Managing Director of Sage Advisory, said, "We are at a turning point where what was originally bad economic news is now seen as good news because it will be the catalyst to force the Federal Reserve to change policy. However, if the data continues to be weak, this backdrop will disappoint stock investors and lead to significant market volatility."

Nevertheless, the yield on the U.S. 10-year Treasury note has returned to levels before the latest jobs report was released, recovering most of its recent declines. Previously, the U.S. unemployment rate rose for the fourth consecutive month, raising concerns that the Federal Reserve's aggressive monetary tightening policy is affecting the economy In fact, labor market data (including the August employment report to be released before the next meeting) is as important to traders as inflation data. Federal Reserve officials are increasingly emphasizing the responsibility of full employment and managing price pressures, with the unemployment rate rising to 4.3% last month, well above the Fed's year-end forecast for the unemployment rate.

Mary Daly, President of the Federal Reserve Bank of San Francisco, said on August 5th: "The labor market is slowing down, and we cannot let it slow down to the point of recession, which is very important."

Inverted Yield Curve Signal

The difference between the yields of the 2-year and 10-year U.S. Treasury bonds turned positive at the beginning of last week for the first time in two years, a situation that has preceded four recessions in the past. As anxiety subsides, U.S. bond yields have once again inverted, but the reality is that since the disruption of normal business activities by the pandemic, the economy has not sent out reliable signals.

U.S. bond yield curve turns positive for the first time in two years

Urano from Sage Advisory added: "Quantitative easing has weakened the impact of the yield curve inversion, but that doesn't mean the concept is useless." "It still makes sense, it just takes longer to manifest now."

Thomas Salopek, Cross-Asset Strategy Director at JP Morgan, said that concerns about economic growth risks persist in the stock market, leading to significant position reversals. According to data compiled by Bloomberg, the S&P 500 Index has seen an average peak volatility of 2% over the past 10 trading days, the highest level since November 2022.

Sharp fluctuations in the S&P 500 Index over the past 10 trading days

This explains why traders expect the inflation report on Wednesday to trigger significant volatility. Core CPI data (excluding volatile food and energy components) is expected to rise by 0.2% month-on-month and 3.2% year-on-year. The Fed's target is 2%.

However, if the data is significantly higher or lower, traders may readjust their expectations. This could trigger another round of market turmoil.

"If the Fed cuts rates significantly due to economic slowdown, historically, this is unfavorable for stock returns," said Brooke May, Managing Partner of Evans May Wealth, whose company is buying large-cap tech stocks. "But the economy is not as bad as people imagine. I expect more volatility, and further declines in the stock market in the coming weeks would not be surprising."