QVMS - The December CPI Report Leaves The Market With No Room For Error

Summary

• The December CPI report is critical to the current market narrative.
• After back-to-back cooler-than-expected CPI readings, markets have gotten very optimistic about disinflation in 2023.
• All it will take is one misstep along the way to kill the market's hope of inflation melting away.

The market may have unrealistic expectations regarding the pace at which inflation subsides in 2023. Inflation swaps currently see inflation falling below 2.5% by the summer of 2023, which seems hopeful. This week's CPI reading will be essential in maintaining that view and could prove disastrous if CPI comes in hotter than expected, veering market-based inflation expectations off course.

Analysts forecast CPI for December to rise by 6.5% on a year-over-year basis, which would be 0.6% less than November's 7.1% reading. The not-seasonally adjusted consumer price index is expected to decline in December to 296.69 from 297.71 in November, driving the year-over-year December inflation rate lower.

Meanwhile, the Cleveland Fed is again predicting that inflation will run hotter than analysts' expectations and sees a year-over-year increase of 6.6%. However, over the last five months, the Cleveland Fed has overstated the CPI metric three times, and by wide margins.

Market Sees Inflation Running Cooler

But what the market thinks about the inflation rate may be even more critical. The December CPI inflation swap is pricing a year-over-year increase of 6.4%, or 0.1%, cooler than expectations. But this swap market hasn't been any better at predicting CPI results than analysts or the Cleveland Fed; it may even be worse.

Let's not forget that a year ago, the CPI swap curve saw the CPI inflation rate at 3.45% by now. That proved too optimistic, and hopes for inflation to be below 2.5% by summer 2023 may be too.

The December reading for inflation is essential to keep the market's dreams of inflation melting alive, especially after two weaker-than-expected CPI readings. Back-to-back lower-than-expected inflation readings have resulted in the inflation swap curve shifting lower. More importantly, it has given the market hope that inflation will melt away quickly and that the Fed will never reach its goal of a 5.1% overnight interest rate.

The inflation swap curve had been more elevated and pretty well anchored above 6% or higher when looking at the futures contracts due to expire in five months or less. That shifted dramatically following the October CPI report that came in mid-November.

To maintain the market's current view on inflation, CPI this week will need to come in as expected or cooler again. This matters significantly because a hotter-than-expected number could shift the curve higher again, prolonging the time it takes for CPI to fall below 2.5%.

Because at this point, the expectation is for CPI to fall by the summer, and that is the same time the market is thinking that the Fed may not only have paused hiking rates but thinks the Fed may turn to cut rates. So if there is a delay in the rate of disinflation, and it does not go as the market predicts, then it just means the hopes of any rate cuts begin to melt away and get pushed out further in time.

So a lot is riding on this CPI report and every CPI report to come. All it will take is one or two hotter-than-expected CPI prints along the way to disrupt any hopes of the Fed cutting rates in 2023 and, more importantly, preventing the Fed from getting to that terminal rate of 5.1%. After all, the Fed is only 75 bps away from it achieve its goal.

A Recession to Follow

But the more significant issue for the markets is what a peak in inflation may mean because, since 1960, when CPI has finally turned lower, it has been during a recession. It was the case in 1970, 1974, 1980, 1990, 2001, and 2008. Each peak in inflation and downturn was associated with a recession.

This idea of peak inflation could mean peak economic growth and a period of slowing nominal GDP growth, thus slowing growth overall. That will bleed into S&P 500 sales estimates, an even bigger issue for the market to work through over the coming months.

The December CPI print carries a lot of weight because a hotter-than-expected print could derail the market in a big way, especially given the hopes it has for a steady decline in CPI over the next several months and any possibility for the Fed to stop hiking rates.

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