All eyes on US inflation data as markets attempt to gauge Fed thinking

Volatility here to stay as markets await inflation data

Market sentiment has taken a hit of late, with the furor around the collapse of the Silicon Valley Bank bringing sharp declines for risk assets. This adds yet another concern for traders, with the gains seen throughout equity markets in recent months providing calls for a reversal given economic concerns. Chief amongst those concerns is the recent sticky nature of inflation, with US CPI falling just 0.1% after two consecutive 0.6% declines. Core inflation similarly slowed its decline, easing back from 5.7% to 5.6%. Looking at things from a visual perspective, the recent decline in headline inflation has provided US markets with respite. However, it is clear that we are well above pre-pandemic levels on both headline and core readings.

It is interesting looking at things from a monthly perspective, with the annualized three-month figure signalling how recent short-term moves project towards an annual reading. From a headline CPI perspective, the past three-months have brought expectations of an annual number of 3.5% if we carried on in this vein. That sounds much better than the 6.3% Year-on-year number we are currently contending with. From this perspective, the ability to post a monthly CPI figure around 0.2% or 0.3% would be a boost given the fact that it keeps that annualized figure within a healthy range. However, markets are forecasting a figure around 0.4%, which would annualize to 4.8%. Looking at the core CPI figure, we can similarly see that recent monthly inflation figures have signalled a potential annual figure around 4.6%, compared with the current yearly reading of 5.5%. Both are significantly above the 2.5% average seen pre-pandemic.

The key thing to concern markets is whether we are seeing inflation stall once again or continue the decline seen over the course of the past nine-months. Markets are currently expecting to see headline inflation down from 6.4% to 6.0%, while core eases back from 5.6% to 5.5%. This would further highlight the sticky nature of core inflation, with the Federal Reserve undoubtedly aware of the need to keep tightening in a bid to put pressure on prices. As such, while the main inflation figure will be a headline grabber if it drops to 6.0% as expected, the stubborn nature of core CPI will be important given the signal it will send the Fed if it continues to struggle at these lofty levels.

The chart below highlights how any uptick in inflation would go against market expectations of a steady decline back down towards target. Such a move would likely cause the Fed to take a higher for longer approach, to the detriment of risk assets.

Dollar index head lower

The dollar has struggled of late, with market expectations shifting away from a 50-basis point hike given concerns around the banking sector. However, it is worth noting the fact that at 38% to 62%, there is still a huge amount of interest rate uncertainty that will be influenced by Tuesday’s inflation data.

A higher than expected inflation reading could lift the dollar given the potential impact it has on Fed thinking. Meanwhile, the recent dollar decline has taken price through 103.75 support, signalling the potential for further downside. A notable decline in CPI and particularly core CPI could help further drive down the dollar, extending the reversal from 105.37 seen of late.