When 0.2% becomes worth 2%

By: Steve Sosnick, Chief Strategist at Interactive Brokers

All eyes were upon this morning’s July CPI report, and it turned out to be a piece of good news.  Headline CPI rose by 8.5% since last year, better than the 8.7% expectation and an improvement over last month’s 9.1% reading.  The core rate, excluding food and energy for those of us who neither eat nor drive, also read 0.2% better than the 6.1% expectation, coming in at an unchanged 5.9%.  As a result, the month-over-month results were also 0.2% better than expectations, meaning that CPI was unchanged from last month.

Stock and bond traders alike relished the news.  And they should.  Any improvement in the inflationary picture is good news for pretty much everyone.  Lower inflation means that purchasing power and asset values are eroded at a slower pace.  Of course traders are responding positively.

As usual though, equity traders are responding more positively than other asset classes might indicate.  Indeed, stocks are typically more volatile than bonds and thus more prone to outsize moves on exogenous data.  That said, much has been made of VIX ticking below 20 for the first time since April.  I don’t like to read too much into specific levels of VIX, though it is clear that its relatively low level and the relatively steep contango of its futures indicate that traders are somewhat sanguine now, but a bit warier of the months to come.  With the Fed still lurking around with restrictive policies, that wariness seems warranted.

I’ve already been asked several times today whether today’s numbers take a 75 basis point hike off the table for the next FOMC meeting.  As of now, I think that equity traders are more excited about that possibility than the fixed income traders who focus more closely on potential rate moves.

Fed Funds futures offer the purest view of the market’s anticipation for future rate moves.  A 50 basis point hike is the base case, with futures indicating the likelihood of an additional 25 bp on top of that, making 75bp.  As of yesterday, the probability of that extra 25bp was 73%.  As I write this, it is 50%.  We’ve gone from a high likelihood to a coin toss after today’s CPI report.  That’s an improvement, but I’d be hard pressed to say that 75bp is off the table – especially when the Fed’s preferred inflation measure, the Core PCE Deflator, is set for release two weeks from tomorrow. 

Short-term bond yields have also curbed their enthusiasm.  The 2-Year yield is now lower by 10bp, giving back nearly half of its peak drop after the report.  The 2-10 inversion has also improved, but to 40bp, which is still a historically high (low?) level.  Recessionary concerns have eased somewhat, but are still clearly quite high.  Oh yeah, and the increased pace of quantitative tightening is still set to begin in September, prior to the FOMC meeting on the 21st.

Bottom line – today’s CPI report was a good one.  Traders of all stripes should be encouraged.  But whether the modest improvement is sufficient to cause a change in Fed policy remains a very open question.

This post first appeared on August 10th, 2022 on the Traders’ Insight blog

PHOTO CREDIT: https://www.shutterstock.com/g/lightspring


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