The upcoming Consumer Price Index (CPI) report on February 14 is poised to deliver a heavy blow to the stock market. The market has been on a meteoric rise since the start of 2023, fueled by dreams of lower inflation and the possibility Federal Reserve interest rate cuts. However, if the report reveals the expected change in trend from the previous two months of disinflation, it could shatter market hopes and trigger a significant market reversal. The report could mark a turning point in stock market expectations for inflation and interest rates, with far-reaching implications.
Analysts expect the headline CPI to rise 0.5% month-on-month and 6.2% year-on-year. Meanwhile, core CPI is expected to rise 0.4% month-over-month and 5.7% year-over-year.
Headline CPI year-over-year is expected to rise 6.5% year-over-year in December, while core CPI fell 5.7%. However, headline CPI is expected to jump month-over-month from the recently revised 0.1% increase in December, while core CPI is expected to remain stable at 0.4%.
The recent revision of the CPI has also reweighted the different components, leading to changes in their relative importance. For example, energy, which had provided a significant deflationary impulse in the second half of 2022, will see its weight drop to 6.92% from 7.86%. Meanwhile, the importance of housing increased significantly from 32.92% to 34.41%, while used cars and trucks fell to 2.66% from 3.62%.
These weighting changes could cause the CPI to rise at the start of the year. For example, the inflationary impulse from owner’s equivalent rent should continue to push prices up for some time, while the impact of falling used car prices will be less pronounced.
The revised data suggests that inflation was lower in the first half of last year compared to the second half of the year. The disinflationary impulse that the stock market was focusing on was not as strong as initially thought and was almost non-existent.
Higher prices and shifting importance
Additionally, January saw significant gains in some declining factors in the second half of the year, such as used cars and gasoline. Manheim’s used vehicle index rose 2.5% in January, which could indicate that the actual CPI used vehicle index will also rise in the coming months. Manheim’s used auto value is typically 1-2 months ahead of the actual CPI used vehicle index. However, the positive impact of these gains should be limited due to their lower weighting in the revised CPI.
Meanwhile, rising gasoline prices are also expected to provide a positive boost to CPI in January, despite gasoline weighting falling to 3.17% from 3.95%.
Additionally, health insurance, which has been a disinflationary force on the CPI since the October reset, has seen its weight reduced, meaning that the disinflationary force will likely be weaker in the January report. For example, in the October report, health insurance had a weight of 0.92% and fell 4%, negatively impacting prices by 0.037%. The same impact with the new weighting of 0.77% would mean that it would have only decreased by 0.031%.
Pricing in case of higher inflation
The January CPI report will be difficult to interpret due to weight changes and recent gains in some inflationary factors. If the trend of a higher than expected CPI continues, this could pose a considerable risk. Trends in the inflation swap market were generally bullish, with the year-over-year increase in swaps in January rising from a low of 5.88% on January 10 to 6.2% on February 9, which is in line with analyst consensus estimates for the January report.
Additionally, prices in the 1-month zero-coupon inflation swap market continued on Friday to show rising inflation expectations for January. Based on my current calculations, the prices suggest that the market expects the CPI to rise 6.22% in January year-over-year, a continuation of the upward trend in inflation, and may even indicate that the market thinks that actual headline inflation could come in above consensus estimates.
This trend is not limited to January alone; it is also evident every month until June. Swaps for March have risen almost 60 basis points over the past month, while the expected reading for June has fallen from a 2% increase to 2.55%. These changes suggest that the market expects higher inflation in the coming months.
It’s not just inflation swaps that embed higher inflation rates; the bond market also reflects this trend. The 1-year break-even inflation rate, which measures the spread between nominal and real yields, rose to 2.62%, well above the lows of 1.63% seen on Jan. 9. This rise in break-even inflation suggests that the bond market is also anticipating higher inflation shortly.
Additionally, the University of Michigan’s one-year inflation expectation rose to 4.2%, the first time it rose in three months. Although it remains below its highs, it is consistent with inflation swaps and bond market developments. This suggests that inflation expectations are on the rise for several market indicators.
Bet on higher interest rates
Additionally, there have been recent bets in the SOFR futures market that suggest traders see the Fed Funds rate hitting 6% by the September FOMC meeting. Open interest for the September 94 SOFRA strike price jumped 178,000 contracts from 44,000 on 6 February. This implies that the federal funds rate is 6% or higher on the expiration date.
Complacency in inventory
Despite all the warnings from various parts of the markets, the stock market continues to live in a fantasy land. He doesn’t seem very concerned about the upcoming CPI report. Implied volatility for Tuesday’s report is just 23.6%, well below readings of 35.8% two days before the January CPI report, 27.95% in December and 40.7% in November. This suggests that the stock market may not be fully pricing in the potential impact of higher inflation on the economy and stock prices.
It appears that despite analysts expecting inflation to rise and warnings from inflation swaps, options and the bond market of a potential higher than expected inflation trend in the future, the equity market is still unconscious.
Therefore, it is possible that there is indeed a warmer than expected CPI report this week, which so many parts of the market seem to be anticipating. If the CPI turns hotter than expected, the stock market could find itself on the wrong side of the trend, as it has done on several occasions over the past 12 months.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these actions.