Stock Market Melts Down Before US CPI Report. What's Wrong?

Key Concepts

• CPI (Consumer Price Index): A measure of the average change over time in the prices paid by urban consumers for a basket of consumer goods and services.
• Core CPI: CPI excluding food and energy prices, providing a clearer picture of underlying inflation trends.
• ISM PMI (Institute for Supply Management Purchasing Managers' Index): An economic indicator derived from monthly surveys of private sector companies, indicating expansion or contraction in business activity.
• Break-even Inflation Rate: The difference between the yield on a nominal Treasury bond and an inflation-indexed Treasury bond (TIPS), representing market expectations for future inflation.
• Risk-On/Risk-Off: A market sentiment describing investor appetite for riskier assets (risk-on) versus safer assets (risk-off).
• Shadow Fleet: A network of tankers used to circumvent sanctions by transporting oil from sanctioned countries like Russia.
• Quantitative Tightening (QT): A contractionary monetary policy used by central banks to reduce the amount of liquidity in the financial system.

Market Volatility and the Upcoming CPI Report

The markets experienced a significant downturn, characterized by widespread selling across stocks, energy, and metals, while bonds rallied. This occurred in the lead-up to the release of the US CPI report on Friday, creating a volatile environment. The speaker, Pivac, Head of Global Macro at Tasty Live, questions whether the market’s reaction is justified, a form of pre-positioning, or driven by a specific catalyst. The S&P 500 fell 1.5%, the NASDAQ nearly 2%, the 10-year Treasury yield dropped 1.8%, and the 2-year yield fell almost 1.7%. Crude oil and gold also experienced substantial declines. Notably, the US dollar remained relatively stable, indicating a move to safety and quality rather than a full-blown flight to liquidity.

Shifting Narratives and Asset Performance

Several key speculative narratives driving market performance have seen liquidation.

• Precious Metals (Gold): Gold, previously driven by concerns over geopolitical risks, weaponization of economic systems, and the decline of sovereign value, reversed course. It had been largely ignoring traditional catalysts like the dollar and yields.
• Crude Oil: The narrative surrounding potential oil price increases due to disruptions in supply from Russia, Venezuela, and Iran (and the impact on China’s oil access) also weakened.
• AI Narrative: The technology sector, particularly the NASDAQ, led the market decline, signaling a distribution phase in the AI-driven rally.
• Bitcoin: Bitcoin continued its downward trend, accelerating alongside the broader market sell-off.

CPI Data Expectations and the Fed’s Position

The upcoming CPI report is expected to show both headline and core CPI falling to 2.5% year-over-year, nearing the Federal Reserve’s 2% target. Headline CPI would reach an 8-month low, and core CPI would be the lowest since March 2021. The Fed’s argument centers on the idea that goods inflation, initially driven by tariffs, is plateauing, and year-over-year comparisons will normalize as the impact of those tariffs fades. Specifically, January 2025 data will be compared to January 2024 data, factoring in the existing tariffs. Goods inflation has been negligible in recent months, and core services inflation is trending downwards, supporting the Fed’s outlook. Currently, 85% of the 2.7% inflation rate is attributed to core services.

Economic Activity and Inflationary Pressures

Despite the positive CPI expectations, concerns remain regarding the strength of the US economy and potential inflationary pressures.

• Service Sector Strength: The ISM Services PMI has shown accelerating economic activity, reaching a 14-month high in December and January. This suggests a potentially overheating economy. The composite PMI, weighted 70% services/30% manufacturing, indicates overall economic growth.
• Manufacturing Rebound: Manufacturing activity unexpectedly surged, exceeding the 50 mark (indicating expansion) to levels not seen since early 2022. Price sub-indexes within the ISM survey are also showing signs of perking up.
• Energy Prices: Crude oil prices have been rallying, potentially adding to inflationary pressures. The current rise appears more sustained than previous spikes linked to geopolitical events.
• Break-even Inflation Rates: Market-implied inflation expectations, as measured by the 5-year and 10-year break-even rates, are rising in tandem with crude oil prices, signaling growing inflation concerns. There's approximately a one-month lag between crude oil movements and their impact on CPI.

Market Expectations vs. Fed Policy

The market currently anticipates two rate cuts in 2024, with the first in June and the second in September. However, the Fed remains committed to only one cut, a stance maintained since June 2023. This divergence between market expectations and Fed policy creates tension. The market’s desire for rate cuts is driven by broader economic policy uncertainty, particularly regarding trade policy and potential disruptions to global supply chains. Global trade volumes fell in 2023 for the first time since the COVID lockdowns, impacting the AI-driven tech rally which relies on a frictionless global supply chain.

Jobs Report Analysis

The recent jobs report presented a mixed picture. While the topline number (130K jobs added) exceeded expectations (70K), and the unemployment rate fell to 4.3%, significant downward revisions were made to previous job growth figures for 2024 and 2025. The revisions were substantial enough to resemble recession-level declines, creating ambiguity about the labor market’s strength.

Positioning and Outlook

Pivac’s current positioning reflects a cautious outlook:

• Short Dollar: Maintaining a short position, anticipating potential dollar weakness.
• Long Aussie, Pound, Euro: Long positions in these currencies.
• Risk-Off Exposure: Hedging with puts on the NASDAQ and S&P 500.
• Long EWZ (Brazil ETF): Benefiting from the rally in the Brazilian market.
• Short Bitcoin: Profiting from Bitcoin’s continued decline.
• Long Gold (via Put Selling): Utilizing a strategy to benefit from gold’s stability.
• Long Crude Oil: Capitalizing on the upward trend in crude oil prices.

Conclusion

The market’s recent downturn reflects a confluence of factors: concerns about the strength of the economy, rising inflationary pressures, and a divergence between market expectations and the Federal Reserve’s policy outlook. The upcoming CPI report will be crucial, but even a benign reading may not be enough to quell concerns if the service sector continues to heat up and energy prices remain elevated. The underlying tension stems from broader economic policy uncertainty and the market’s desire for a safety net of cheap money to mitigate potential risks. The situation remains fluid, requiring careful monitoring of economic data and Fed communication.