Will US CPI Inflation Data Crush the Stock Market?

Here's a detailed summary of the YouTube video transcript:

Key Concepts

US CPI Inflation Report: The primary focus of the discussion, detailing expected year-on-year inflation rates for both headline and core CPI.
Federal Reserve (Fed) Monetary Policy: Expectations for upcoming interest rate cuts, particularly the 25 basis point cut anticipated for the October meeting.
Market Expectations vs. Fed Projections: Discrepancies between market pricing for future rate cuts and the Fed's own Summary of Economic Projections (SEP).
Goods vs. Services Inflation: Analysis of inflation trends in different sectors, with a focus on the recent rise in goods inflation and its potential impact on services inflation.
Tariffs and Inflation: The argument that tariffs are contributing to rising goods inflation.
ISM Services Index: A private sector survey used as a leading indicator for inflation.
Inflation Expectations: How inflation expectations are reflected in bond markets and the US dollar.
Economic Data and Market Reactions: The impact of economic data, particularly CPI, on stock market and currency movements.
Geopolitical Events: The influence of sanctions on Russian oil producers and their impact on crude oil prices.
Trading Positions: The speaker's current market exposures.

US CPI Inflation Data and Market Impact

The video discusses the upcoming US CPI inflation report, which is a crucial piece of economic data after a period of limited releases due to the US government shutdown. The markets are keenly awaiting this report, as it will influence Fed monetary policy expectations and, consequently, stock market movements.

Market Price Action (Current Day)

Stocks: Slightly higher today after yesterday's sell-off, with the S&P 500 up approximately 0.61% and the NASDAQ up nearly 1% (0.9%). Over the past 48 hours, the markets have been largely unchanged.
Yields: Up, with the 10-year Treasury yield at 1.26% and the 2-year Treasury yield at 1.3%.
Crude Oil: Experienced a significant surge of 5.54% following US sanctions on Russian oil producers Lukoil and Rosneft. These sanctions aim to pressure China and India to cease business with these entities, threatening exclusion from the US financial system. This is compared to previous US actions against banks related to Iran and Huawei. The sanctions are intended to compel Russia to negotiate an end to the war in Ukraine. A potential supply shock could occur if China and India significantly reduce their purchases of discounted Russian oil, forcing them back into the open market.
Gold: Up only slightly, despite geopolitical escalation. This is notable given that gold experienced its largest daily decline (over 5%) since August 2020 earlier in the week.
US Dollar: Flat against the Euro.
Yen: Weakening slightly due to the solidification of the new government in Japan, led by Prime Minister Sana Takahichi, who is perceived as dovish and supportive of Bank of Japan's (BOJ) expansionary policies, reminiscent of "Abenomics."
Bitcoin: Following the trend of stocks, it's up slightly but has not seen significant movement in recent days.

US CPI Inflation Report Specifics and Expectations

The core focus is on the upcoming US CPI report.

Expectations: Both headline and core CPI are expected to come in at 3.1% year-on-year.
Core CPI: This would mark the third consecutive month at 3.1%, indicating a stable trend.
Headline CPI: A 3.1% reading would be a significant departure from recent trends and would represent the highest headline inflation rate since May 2024, a 16-month high. This could influence Fed officials' thinking and market expectations for monetary policy.

Federal Reserve Monetary Policy Expectations

The video analyzes market pricing for upcoming Fed meetings.

October Meeting: There is an overwhelming expectation (nearly 99% probability) for a 25 basis point rate cut. This expectation has solidified over time and was previously around 80-90%. A 50 basis point cut, which was considered a week ago, is no longer a significant consideration.
December Meeting: Similar to October, there is a high probability (well into the 90s) of another 25 basis point cut. However, there's a slightly higher chance (though still a "pittance") of no change at this meeting compared to October, suggesting markets are more open to considering alternative outcomes further out.

Market Pricing vs. Fed Projections (Beyond 2024)

The larger question for the markets, and the focus of the discussion, is not the outlook for the remainder of 2024 but what happens thereafter.

2024 Outlook: Markets are largely aligned with the Fed's view for 2024. The Fed's Summary of Economic Projections (SEP) indicated three cuts for the year, with the median starting at 4.4% and expected to reach 3.6%. This implies three cuts have already been priced in, aligning with market expectations.
2025 Outlook: A significant divergence exists between market expectations and the Fed's projections for 2025.
- Fed Projection: The Fed's SEP anticipates only a single 25 basis point cut for 2025.
- Market Expectation: Markets are pricing in approximately three cuts for 2025, totaling around 68 basis points. This includes a 50 basis point cut already priced in, and an implied probability of 72% for an additional 25 basis point cut.
Market Dovishness: Markets have become increasingly dovish in their policy expectations, particularly since the initial rate cut and during the government shutdown. The prevailing view is that the Fed's projections are too hawkish and that more cuts will be necessary.
Fed's Counterpoint: The Fed's perspective is based on upgraded GDP and inflation expectations in their recent update. This presents a risk: if the Fed is correct about higher inflation, markets may need to reassess and adjust their dovish expectations.

Inflation Dynamics: Goods vs. Services and Tariffs

The video delves into the components of inflation.

Goods Inflation:
- Trend: Goods inflation has been anemic for a long time, but recent data shows it reaching a more than two-year high.
- Tariff Impact: The speaker argues that tariffs are directly contributing to this rise in goods inflation, noting an escalating trend over the past three months. This contradicts the view that tariffs are not driving inflation.
Services Inflation:
- Trend: Services inflation has shown cooling trends over the past three months.
- Significance: Services inflation is a much larger component of the overall economy than goods inflation.
Interplay: A key concern is whether the rise in goods inflation will eventually lead to a rebound in services inflation, as goods are inputs into many services.
Housing Inflation: A significant jump in housing inflation was observed in August. While the long-term trend in housing inflation has been weakening, this recent uptick could be a turning point.

Annualized Inflation Trends

Three-Month Annualized Rates: Both headline and core inflation's three-month annualized rates show dramatic departures from the slowing inflation trend observed since the beginning of the year.
Month-on-Month Changes: Month-on-month changes in inflation have been growing larger since March.

ISM Services Index and Inflation Foreshadowing

ISM Services Index: This private sector survey from the Institute for Supply Management (ISM) is not affected by the government shutdown.
Leading Indicator: The ISM services index tends to front-run headline CPI and PCE by approximately two months.
Implication: If the current trend in the ISM services index continues, it suggests that inflation is on the cusp of surging. This would further challenge the market's expectation of numerous Fed rate cuts.

CPI vs. Cleveland Fed's Nowcast

Overshooting Forecasts: Both headline and core CPI have recently overshot the benchmark nowcast from the Cleveland Fed.
Headline CPI: Has been surprising on the upside for the past four to five months.
Core CPI: Was running cooler but started to surprise higher from July to August. This single month of data might indicate that the factors influencing headline inflation are beginning to impact the slower-moving core CPI.

Market Expectations and Divergent Signals

The video highlights a disconnect between market expectations and certain asset movements.

Inflation Expectations in Bond Market: Inflation expectations baked into the bond market have been declining since mid-August, contributing to lower yields and a flatter yield curve. This aligns with the market's expectation of Fed easing.
US Dollar Strength: Despite declining inflation expectations and dovish Fed pricing, the US dollar has been strengthening since mid-September. This suggests the dollar is not aligning with the market's dovish narrative.
Stocks and Fed Policy Expectations: A breakdown in the relationship between stocks and Fed policy expectations has occurred since the beginning of October. Previously, more dovish policy expectations boosted stocks. Now, even as policy expectations become more dovish, the stock market remains range-bound.
Dollar and Fed Policy Expectations: Similarly, as policy expectations become more dovish, the dollar is moving higher, indicating a divergence.

Potential Explanations for Divergence

Market Reassessment: Markets may be starting to realize that their dovish expectations are incorrect and need adjustment.
Data Dependence: The lack of economic data due to the shutdown might have led to markets ignoring the Fed. The upcoming CPI data could trigger a snapback and re-engagement, with the direction depending on the report's outcome.

Upcoming Economic Data and Earnings

Growth Dynamics: Beyond CPI, the Eurozone's composite number and US growth data (for October) are important. Expectations are for steady manufacturing and a slight cooling in services.
Atlanta Fed's GDP Now: The tone of incoming data, as reflected in the Atlanta Fed's GDP Now forecast, has been positive, suggesting more inflationary pressure and less scope for rate cuts.
Citigroup's Economic Surprise Index: This index shows a narrow outperformance of US economic data relative to expectations, also supporting the idea of fewer rate cuts.
Earnings: While some earnings are scheduled for tomorrow, they are not as significant as the major tech earnings expected the following week.

Speaker's Trading Positions

Crude Oil: Exited long position yesterday, avoiding the recent spike.
Dollar: Long against the Australian Dollar, Pound, Euro, and Canadian Dollar (short on these currencies).
Gold: Still short a small amount, influenced by the recent sell-off and weak recovery.
Risk: Short risk through put verticals against the NASDAQ and S&P 500, as well as Bitcoin.
Bonds: Long long-term bonds. The speaker believes that while CPI might spook near-term rate cut expectations, it might not significantly hurt the long end. Pushed-out rate cuts could lead to a steeper curve and potentially more cuts beyond 2026.

Conclusion and Next Steps

The upcoming US CPI report is critical for understanding inflation trends and their implications for Fed policy. The current market pricing for rate cuts appears to be at odds with potential inflationary pressures, particularly from goods and potentially services. The speaker suggests that markets may need to reassess their dovish expectations if the Fed's view on inflation proves correct. The video concludes by mentioning upcoming shows and the speaker's commentary platforms.