Inflation is no longer a major issue, with CPI on the day possibly marking the smallest market fluctuation of the year

Since the Federal Reserve began actively combating inflation two years ago, stock traders have been glued to their screens every time the Consumer Price Index (CPI) is released. However, this week's latest CPI data should be different.

Why? Because as inflation trends lower towards the Fed's target, the Fed is preparing to cut rates, making this data less important for the stock market. Instead, everything is related to the soft job market and whether the Fed can avoid a hard landing.

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

The S&P 500 just ended its worst week since the Silicon Valley Bank collapsed in March 2023, with large tech stocks falling and NVIDIA 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 on even greater volatility, but lower than the market's expectations for CPI day. As of last Friday morning, they expected the S&P 500 to fluctuate by 0.85% on Wednesday. Data compiled by Piper Sandler shows that if this target is achieved, it will be the smallest CPI day volatility so far this year. On the other hand, ahead of the weak non-farm payroll report released last Friday, traders expected the implied volatility of the S&P 500 to be 1.1%. According to data compiled by Susquehanna International Group, this is one of the highest absolute values this year, 83% higher than the average implied daily volatility in 2024. The index fell by 1.7% that day, even exceeding expectations.

"The stock market has been strong this year," Diton said. "So why not take some profits?"

Basically, the market's perception has shifted, with rate cuts now seen as inevitable, but the economy's strength seems less solid. On August 23, Federal Reserve Chairman Powell almost declared victory in the fight against inflation at the Fed's symposium in Jackson Hole, Wyoming. Since then, more policymakers such as New York Fed President Williams, Chicago Fed President Gülsün, and Fed Governor Waller have all 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 to maintain maximum employment. According to data from the U.S. Bureau of Labor Statistics, Friday's jobs report showed that non-farm payrolls increased by 142,000 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 18th, the forward contracts fully reflect the expectation of at least a 25 basis point rate cut. Meanwhile, data compiled by UBS Group shows that implied volatility is accelerating before major macro events related to employment, with stock market volatility indicators (such as skew) still at high levels as traders hedge against further downside risks in the stock market. Rocky Fishman, founder of derivatives analysis company Asym 500, said, "The skew indicates that there is additional value in providing downside protection for hedging. If viewed 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 employment data day since 2022 last month, falling 1.8% on August 2nd (Friday) and another 3% on August 5th due to weak employment reports. Two weeks later, inflation data was largely in line with expectations, with the S&P 500 index rising only 0.4%, the smallest single-day increase in CPI since January.

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 are positioning themselves for asset price trends through long and short bets, believing there is hardly any room to add positions now. The VIX, a volatility index measuring the implied volatility of benchmark US stock index futures through over-the-counter options, is currently at a low level just above 20. This level itself does not necessarily indicate danger, but the index is 52% higher than the average level this year, and the volatility curve implies that risks will rise in the coming months.

Federal Reserve officials have entered a pre-meeting blackout period and will not make any comments before September 18th. However, the latest Beige Book shows that compared to inflation, business contacts are more concerned about slowing economic growth. The Beige Book compiles information from business contacts in 12 regions. However, the report does not mention "economic recession," mentioning "inflation" only 10 times - according to DataTrek Research, this is the lowest level since 2024.

While there is a general expectation that the US economy will remain strong, the Atlanta Fed's GDPNow model shows some slowing, with the third-quarter real GDP growth rate expected to be 2.1%, down from around 3% a few weeks ago. This is yet another signal that the Federal Reserve may need to cut rates before it's too late to prevent an economic downturn. If they don't, investors who have pushed up the stock market in anticipation of policymakers soon lowering borrowing costs may have to consider the old saying, "Be careful what you wish for."

Diton said that if the stock market intensifies its concerns about the Federal Reserve's inadequate response to economic slowdown, the situation will be particularly dire. Economic slowdown will ultimately impact corporate profits. "Everyone is now paying attention to every data point on the economy and employment," he said. "If the data continues to weaken, there will be more selling."