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US markets keeping close tabs on inflation outlook

The US Treasury Department

The US consumer price index (CPI) reading for December, due out on 12 January, is expected to show that inflation continued to ease last month. Analysts estimate that consumer prices increased 6.5% in the year to December, down from 7.1% in November. On a monthly basis, CPI is expected to show no change versus November. 

Meanwhile, so-called core CPI, which removes volatile food and fuel costs, is thought to have risen 5.7% year-on-year in December, down from 6% in November. Estimates also suggest that it rose 0.3% month-on-month. 

Analyst expectations are broadly in line with official predictions. The Cleveland Fed estimates that headline CPI increased 6.6% in the year to December, with core CPI up 5.9%. 

Although the Cleveland Fed has a reliable track record of accurately forecasting inflation, it overestimated CPI in both October and November, as the chart below shows. However, it would be a big blow for markets and those hoping for lower inflation if CPI for December were to exceed the Cleveland Fed's estimate of 6.6%.

Priced to perfection?

US markets appear to be accurately pricing in expectations of falling inflation. Currently, the December CPI inflation swap is pricing in an annual increase of 6.4%, just below analysts' estimates of 6.5%. However, inflation swaps have been a less accurate predictor of CPI than the Cleveland Fed over the past few months, either overstating or understating the actual CPI print. 

The swaps market matters because it is the easiest way to gauge what the market is thinking when it comes to the path that inflation may take over the next 12 months. As the chart below indicates, the market expects inflation to drop below 2.5% within seven months – a rapid decline. 

Based on these expectations for a sharp fall in CPI, the market believes that the Federal Reserve will cut rates in 2023. 

The next chart, below, plots these inflation expectations alongside the Fed Funds Futures curve. It shows that the first drop in Fed Funds rates is set to occur in seven months’ time, with expectations that it will then keep falling. This partly explains why the market is at odds with the Fed. At this point, the market believes that inflation will fall faster than the Fed expects. 

If the CPI reading for December comes in cooler than expected, rates could fall and the dollar might weaken. That would likely lift stock prices. In contrast, a hotter-than-expected CPI print could push rates and the dollar higher, sending stock prices lower. Thursday’s CPI report is therefore very important as it will shape market expectations. 
With the Fed having raised interest rates by 0.5 percentage points in December, bringing the target range for its benchmark rate to 4.25% to 4.5%, the central bank is closing in on its projected terminal rate of 5.1%. The market and the Fed are broadly aligned here, though markets expect peak rates to come in 0.25 to 0.5 percentage points below the Fed’s 5.1% target. 

Soon, the focus is likely to shift from inflation to the broader economy. Provided that the economy holds together, the Fed’s narrative will evolve from raising rates to holding rates high. As it sticks to its goal of bringing inflation under control, the Fed is unlikely to be in any rush to cut rates.

Markets still fear the fed

While the market and the Fed differ in their views on inflation, the market clearly fears the Fed. There have been numerous opportunities for the two-year Treasury note to break lower, but it hasn't been able to drop below the 4.20% level. On Friday 6 January, the 2-year moved down to 4.25% following a weak Institute of Supply Management (ISM) services index report, which suggested that the US economy could be heading towards a recession. 

The 4.20% level is key. As long as the 2-year holds above 4.20%, it is more likely to move higher. A drop below 4.20% would likely result in a severe decline. Yet despite the economic data, and assuming that the Fed keeps interest rates high, a move lower for the 2-year appears unlikely in the near term. 

Dollar weakness

The euro is showing signs of trying to break out, having recently risen above $1.075. This is a big move higher for the euro and could imply further upside potential to around $1.09 if the CPI report comes in cooler than expected. 

The pound is also showing signs of strength versus a weakening dollar. The pound is getting very close to breaking above a downtrend, with significant resistance at $1.2175 and the potential to rise all the way back to $1.245.

Stock indices could be set to fall

For The Nasdaq 100, the big rally on 6 January didn't accomplish much, with the index moving back to the upper end of its trading range. Mostly, it looks like an incomplete bear flag pattern in the Nasdaq, and much more like a consolidation pattern than a reversal pattern. It is possible that there could be some further upside, allowing for a gap to fill to around 11,225. However, it seems more likely that the index will break lower and head below 10,690. 

Meanwhile, the Dow Jones Industrial Average has outperformed over the past several months. Interestingly, a similar thing happened in 2001, when the broader Nasdaq and the S&P 500 drifted lower. Whether or not the outcome will be the same this time remains to be seen, but the similarities are notable and could suggest a sharp sell-off to come. 

Of course, the CPI report could alter the course of these technical charts. However, the current picture seems to favour interest rates staying elevated and markets struggling to rally. 

Simply put, little has changed. The market appears to be priced to perfection, with everything going its way. One hotter-than-expected CPI report may be all it would take to dash the market's hopes for a swift end to inflation.

Charts used with the permission of Bloomberg Finance LP. This report contains independent commentary to be used for informational and educational purposes only. Michael Kramer is a member and investment adviser representative with Mott Capital Management. Mr Kramer is not affiliated with this company and does not serve on the board of any related company that issued this stock. All opinions and analyses presented by Michael Kramer in this analysis or market report are solely Michael Kramer's views. Readers should not treat any opinion, viewpoint, or prediction expressed by Michael Kramer as a specific solicitation or recommendation to buy or sell a particular security or follow a particular strategy. Michael Kramer's analyses are based upon information and independent research that he considers reliable, but neither Michael Kramer nor Mott Capital Management guarantees its completeness or accuracy, and it should not be relied upon as such. Michael Kramer is not under any obligation to update or correct any information presented in his analyses. Mr. Kramer's statements, guidance, and opinions are subject to change without notice. Past performance is not indicative of future results. Past performance of an index is not an indication or guarantee of future results. It is not possible to invest directly in an index. Exposure to an asset class represented by an index may be available through investable instruments based on that index. Neither Michael Kramer nor Mott Capital Management guarantees any specific outcome or profit. You should know the real risk of loss in following any strategy or investment commentary presented in this analysis. Strategies or investments discussed may fluctuate in price or value. Investments or strategies mentioned in this analysis may not be suitable for you. This material does not consider your particular investment objectives, financial situation, or needs and is not intended as a recommendation appropriate for you. You must make an independent decision regarding investments or strategies in this analysis. Upon request, the advisor will provide a list of all recommendations made during the past 12 months. Before acting on information in this analysis, you should consider whether it is suitable for your circumstances and strongly consider seeking advice from your own financial or investment adviser to determine the suitability of any investment. Michael Kramer and Mott Capital received compensation for this article.

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