Stocks, Crude Oil, and the Dollar: Will This Block Fed Rate Cuts?

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, considered a better indicator of underlying inflation trends.
• PPI (Producer Price Index): A set of indexes measuring the average change over time in the selling prices received by domestic producers for their output.
• Nowcast (Cleveland Fed Nowcast): A real-time forecasting model that uses various economic indicators to predict current economic conditions.
• Tariff Impact: The effect of tariffs on goods inflation and the willingness of wholesalers to absorb those costs through reduced margins.
• Crude Oil Impact on Inflation: The lagged effect of crude oil price changes on CPI.
• Fed Rate Cuts: Anticipated reductions in the federal funds rate by the Federal Reserve to stimulate economic activity.
• USO: United States Oil Fund, an exchange-traded fund that tracks the price of West Texas Intermediate (WTI) crude oil.
• Shadow Fleet: A network of tankers used to circumvent sanctions and transport oil, particularly from Russia.

Market Response to CPI Data & Emerging Catalysts

The markets exhibited a muted initial response to the latest CPI data, ultimately ending the day with modest losses. However, a significant rally in crude oil – reaching a three-month high with a 2.6% increase – overshadowed the inflation report and became a central focus. Bitcoin also experienced a 3.4-4% pop, but this was within its existing six-week trading range, unlike the breakout seen in oil. The dollar strengthened, gold experienced a slight correction, and yields remained relatively stable. This divergence suggests a new catalyst – the surge in crude oil prices – is influencing market sentiment.

Inflation Data Breakdown

The CPI report revealed a headline inflation rate of 2.7%, in line with expectations. Core CPI came in at 2.6%, slightly below forecast but unchanged from the prior month, marking the lowest reading since early 2021 (March/April). Headline inflation remained at a four-month low set in November.

• Sectoral Breakdown: The majority of inflation continues to reside in the service sector (1.85 percentage points of the 2.7% headline), while goods inflation is showing a slight increase.
• Food & Energy: Shifts in food and energy prices are less relevant to the Fed’s policy decisions as they are outside of the central bank’s direct control.
• Contribution Changes: A slight pullback in energy costs was largely offset by gains in food and core inflation (services and goods).

Fed Policy & Inflation Trajectory

The Fed’s argument for potential rate cuts hinges on a softening labor market and declining services inflation. The expectation is that tariff-related goods inflation will eventually “rebase” out of the calculations by April/May, further aiding the disinflationary process. The recent CPI report, being more “normal” than the volatile data from December, supports this narrative. The Cleveland Fed’s Nowcast model suggests further declines in both headline and core inflation, potentially reaching 2.2% and 2.45% respectively in January. However, the rising oil prices introduce a significant complication to this outlook.

Government Shutdown Impact & Data Validity

The December CPI data was notably more stable and aligned with forecasts compared to the anomalous readings in November and October, which were attributed to counting issues following the government shutdown. The relationship between the current data and the Cleveland Fed’s Nowcast model indicates a return to data validity, suggesting the forecasts are likely reliable.

Crude Oil Surge & Geopolitical Factors

The surge in crude oil prices is driven by emerging geopolitical concerns impacting China’s oil supply.

• Venezuela: US control over Venezuelan oil supplies limits China’s access.
• Iran: Political instability in Iran and US interception of Russian “shadow fleet” oil tankers disrupt traditional supply routes.
• Saudi Arabia/Gulf States: China may need to rely more heavily on Saudi Arabia and other Gulf states, potentially leading to supply constraints and higher prices.

This situation creates a potential for sustained higher oil prices, which, with a roughly one-month lag, could translate into higher CPI readings.

PPI Preview & Margin Squeeze

The upcoming PPI report is expected to show a slight increase, but the key focus will be on the trade services component. This component measures the margins importers have on delivering goods. For months, wholesalers have been absorbing tariff costs by reducing their profit margins to avoid passing them on to consumers. This has helped to keep goods inflation in check. However, this strategy is unsustainable in the long run. If wholesalers are forced to pass on these costs, goods inflation could rebound. Combined with rising oil prices, this could create a more persistent inflationary environment.

Market Positioning & Outlook

The market currently anticipates more rate cuts (at least two) than the Fed has signaled (one). This discrepancy has led to a pause in the S&P 500’s upward momentum. The speaker’s current positioning reflects this uncertainty:

• Long Gold: As a hedge against globalization breakdown concerns.
• Long Dollar: Driven by risk aversion and the expectation of limited Fed rate cuts.
• Short Risk (NASDAQ, S&P, Bitcoin): Through put verticals on tracking ETFs.
• Long Oil (USO): Layered positions starting around $72, with additional purchases at $75, extending to $80 with 94-day duration.

Notable Quotes

• “One of these [crude oil and Bitcoin] is not like the other.” – highlighting the disparity in the market reactions.
• “The markets both registered the data, registered its implications, but did not seem at all moved by what has occurred here?” – questioning the market’s response to the CPI data.
• “If they start to really pass on these costs to consumers in earnest, well then it won't be a flattening picture for goods inflation here.” – explaining the potential for a rebound in goods inflation.

Conclusion

The initial muted market response to the CPI data was quickly overshadowed by the surge in crude oil prices, driven by geopolitical factors impacting China’s supply. While the CPI report itself supported the Fed’s narrative of disinflation, the rising oil prices introduce a significant risk of renewed inflationary pressure. The upcoming PPI report will be crucial in determining whether wholesalers can continue to absorb tariff costs or will be forced to pass them on to consumers, potentially exacerbating the inflationary situation. The speaker’s positioning reflects a cautious outlook, favoring hedges against risk and a long position in oil, anticipating a potentially challenging environment for rate cuts and stock market performance.