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Hot PCE report could quash hopes for end-of-year rally

US inflation is set to be in the spotlight again this week as the PCE reading for October is published on Thursday.

The October reading of the personal consumption expenditures (PCE) price index, due out on 1 December, is expected to show inflation easing slightly from September levels. However, if estimates prove too low, US markets could enter a period of volatility.

In October, the headline PCE price index is estimated to have risen 0.4% month-on-month and 6% year-on-year, while the so-called “core” PCE price index – which strips out volatile food and energy costs, and is said to be the US Federal Reserve’s preferred measure of inflation – is forecast to have increased 0.3% month-on-month and 5% year-on-year. The year-on-year inflation estimates represent modest improvements compared to the previous month. Headline PCE grew 6.2% in the year to September, while core PCE increased 5.1%. 

The Cleveland Fed estimates that PCE and core PCE inflation are running at 6.0% and 5.0%, respectively (see chart, below). But there is a wrinkle here because the PCE and core PCE estimates fell after the consumer price index (CPI) report for October, which came out on 10 November, showed inflation easing to a lower-than-expected 7.7%. However, the post-CPI downward shift in PCE inflation data could be a mistake. In October, technical changes were made to the way in which health insurance costs are calculated in the CPI. These changes will not be made in the PCE report, which means PCE estimates may prove too low. 

Inflation could exceed expectations

The October CPI report saw health insurance costs fall more than 4% month-on-month, the biggest decrease since records began in 2006 (see chart, below). Lower costs for health insurance, which has a nearly 1% weighting in the overall CPI index, exerted a negative drag on headline and core CPI, resulting in both readings coming in below estimates. 

In light of all this, there is a possibility that the PCE measure of inflation could come in higher than expected on Thursday. Given the significant drop in health insurance costs – which form part of the CPI but not PCE – it’s easy to see why the Fed prefers the PCE report. 

Stock market rally may have unstable footing

US stock markets have rallied since the 10 November CPI report, which may leave the S&P 500 in an unstable pattern. The pattern has been repeated several times in 2022, as indicated by the circled areas in the chart below. Typically, this pattern involves a sharp gap higher and a vertical rally. In July and October, these moves gave way over time. This resulted in the S&P 500 falling back and filling the gap, as happened in the second half of August and the middle of October. Now, a similar type of unwinding could result in the S&P 500 falling back to 3,580 and filling the gap from mid-October.

Additionally, the topping pattern in the S&P 500 is a diamond reversal, suggesting that the S&P 500 could see a sharp decline.

The Invesco QQQ ETF, an exchange-traded fund (ETF) that tracks the Nasdaq 100 Index, hasn't recovered nearly as much as the S&P 500, but it does have a similar diamond reversal pattern to the S&P 500, as shown in the chart below. The QQQ has seen the pattern develop multiple times in recent months. Each time, the pattern has resulted in all of the gains being erased. 

In the present case, such a drop could result in the QQQ ETF filling the gap at $263. It would be roughly the equivalent of the Nasdaq 100 Index falling to around 10,800. 

While the PCE report for October is just one of several key economic events this week, it is certainly one for traders to watch. If the technicals play out as they have in the past, the first few days of December may flatten any hope for an end-of-year rally. 

Other events worth monitoring this week include the all-important US jobs report on Friday and, before that, Fed chair Jay Powell’s speech at the Brookings Institution on Wednesday.

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