CPI Outlook: Recession trade or re-inflation trade? Market bets on a huge market shake-up!

At 8:30 p.m. Beijing time on Wednesday, the U.S. will release the CPI inflation data for July. Following the unexpected cold non-farm payroll report that triggered a global stock market crash last week, the market is on high alert for any movement in economic data. Investors continue to remain cautious, and geopolitical concerns continue to weigh on market sentiment.

Observers warn that inflation data could lead to significant volatility in the market in either direction, with weaker-than-expected data exacerbating concerns about the economy, while strong data could weaken bets on a Fed rate cut. The Fed continues to balance between supporting economic growth and trying to control prices, but more and more people believe that recent economic data suggests that rate cuts have come too late.

Market Expectations: Continued Decline Trend

The consensus on Wall Street shows that after recording -0.1% last month, the month-on-month CPI for July is expected to rise to 0.2%, while the year-on-year rate is expected to remain at 3%; excluding the volatile energy and food prices, core CPI is expected to rise from 0.1% in June to 0.2% month-on-month, but is expected to drop from 3.3% last month to 3.2% year-on-year. Economists at Fuguo Bank stated:

"The July Consumer Price Index report may further prove that inflation is calming down, but it has not yet returned to the Fed's target."

Goldman Sachs believes that core CPI will record 0.16% month-on-month, below the market consensus of 0.2%. The bank expects core goods prices to fall to 0.11% month-on-month, but service sector inflation will rise by 0.23%, offsetting this decline, mainly driven by owner's equivalent rent (OER). With hotel prices rising by 0.50%, Goldman Sachs expects OER to rise by 0.29%. Another driving factor is car insurance, with Americans facing shockingly high renewal rates, even making headlines. Goldman Sachs expects car insurance prices to grow by 0.7%.

Will CPI Provide More Evidence for Rate Cuts?

The inflation trend is crucial for the Fed's willingness to cut rates, but monthly data fluctuates significantly. José Torres, Senior Economist at Interactive Brokers, stated that after good inflation performance in May and June, July CPI data is expected to be "moderate." "Energy has become a driving force for inflation. Gasoline prices have slightly rebounded, and we expect new and used car prices to also rise, partly due to lower interest rates," he said. He also expects housing prices, transportation services, and healthcare to rise in July.

For the past two years, U.S. inflation reports have been key in influencing market expectations for Fed rate policy. Prior to the Fed and Bank of Japan meetings in July, the market did not even expect three rate cuts by the end of the year. However, a large unwinding of yen carry trades and a global stock market collapse led bond futures prices to predict that the Fed could cut rates by up to 100 basis points by the end of 2024 Although most subcomponents of inflation have declined since peaking in 2022, they still remain above the Federal Reserve's 2% target, with "super core" inflation, excluding housing inflation, stubbornly holding at around 4.5%. BMO Capital Markets senior economist Priscilla Thiagamoorthy wrote:

"August may need similar strong inflation data (or higher unemployment rates) to convince the majority of FOMC voters that inflation is convincingly moving towards the 2.0% target."

"One of the main risks is the timing and extent of the Fed's rate cuts," said Luca Santos, an analyst at ACY Securities, "If the Fed delays easing monetary policy, the U.S. economy may face further slowdown risks, potentially leading to a recession... Conversely, if the Fed cuts rates too aggressively, it could reignite inflation pressures or cause financial market instability. Balancing these risks is crucial for maintaining economic stability."

EY-Parthenon senior economist Lydia Boussour stated that the July CPI report "will provide more evidence that the process of inflation easing is still ongoing and remains on a normal trajectory." With such results, the report will "strengthen the case for a rate cut by the Fed at the September meeting."

According to the CME FedWatch tool, the likelihood of a Fed rate cut in September is nearly 100%. However, following the soft July jobs report and market turmoil early last week, there is a divergence of opinions in the market on whether the Fed will cut rates by 25 basis points or a more aggressive 50 basis points.

How might the market react?

Due to low market liquidity during the summer holiday period, the market may overreact to any unexpected inflation. An unexpected increase in inflation could reduce expectations of a 100 basis point rate cut by the end of the year, as currently priced in bond futures. Conversely, if inflation data unexpectedly declines, it will solidify expectations of a 50 basis point rate cut in September and more aggressive future rate cuts.

Bloomberg's World Interest Rate Probability Function implicitly predicts the federal funds rate for early 2027, finding great expectations for a significant Fed rate cut next year, with overnight rates expected to drop by at least two percentage points to slightly above 3%.

KCM Trade's Chief Market Analyst Tim Waterer stated, "If U.S. inflation data softens, gold prices will benefit as this will reignite hopes for a significant rate cut by the Fed in September." Gold is considered a hedge against geopolitical and economic uncertainties and often benefits from a low-interest rate environment. Kitco Metals' Senior Analyst Jim Wycoff believes, "The escalating tensions in the Middle East have also brought some safe-haven demand At present, the market is concerned that Iran will retaliate against Israel, triggering a larger conflict in the Middle East. In addition, Ukraine has launched its largest counteroffensive against Russia since the conflict erupted, even crossing into Russian territory, sweeping through parts of western Kursk region, and exposing weaknesses in Russia's border defense in that area.

According to a report by Morgan Stanley, gold is currently seen as a hot trade from any angle, with Wall Street unanimously bullish. It is worth noting that the institution also believes that although market sentiment is generally optimistic, macro funds' positions may have reached their limit, making it difficult to further increase investments in gold unless an economic recession is imminent. This suggests that the upside potential for gold may have already been fully priced in by the market, with limited room for further upside unless driven by significant new economic changes.

In the stock market, there are lingering concerns following last week's "Black Monday" global stock market crash. According to data from Citigroup, based on the implied volatility of call options, traders expect the S&P 500 index to fluctuate by 1.2% in either direction when CPI data is released on Wednesday. Bloomberg data also shows that the price of contracts hedging against a 10% decline in the SPDR S&P500 ETF Trust over the next 30 days is at its highest level since October last year, double the price of contracts hedging against a 10% increase. This is the largest ETF tracking the broad market index.

US Bank analyst Ohsung Kwon pointed out that investors concerned about stock sell-offs triggered by CPI data can buy put options on the S&P 500 index, which is cheaper than hedging with the Russell 2000 index (RTY) or the Nasdaq 100 index (NDX).

Furthermore, on Thursday evening at 20:30, the US will also release retail sales data, known as "terrifying data," which may show a slight increase. However, investors should be cautious, as weak performance in this data could reignite concerns about consumer slowdown and potential recession