ACTV - This Week's CPI Report Could Ignite Massive Volatility

2023-05-07 06:15:00 ET

Summary

• The CPI report will likely create a lot of volatility before and after the data release.
• The reason is that now the Fed is going to be data dependent, which means hot data will drive more rate hikes.
• This will increase overall market volatility heading into the June FOMC meeting.

As the Fed shifts to a data-dependent mode, we can expect increased market volatility, as evidenced by the market reaction on Friday following the hotter-than-expected April Jobs report. Despite this, equity markets rallied, implied volatility dropped sharply, and options call buyers took over in the late afternoon.

On May 10, the next opportunity for volatility will arise with the release of the CPI report. The CPI report has gradually become less significant to the market over the past few months as the rate of change continues to diminish. However, the April report holds some importance, as year-over-year comparables are forecast to ease between now and July. Any deviation in the data could devastate those expecting inflation to return to the Fed's target soon.

Core Inflation Expected To Remain Hot

For April, headline CPI is anticipated to rise by 0.4% month-over-month and 5.0% year-over-year. The month-over-month increase would be higher than March's 0.1% increase, while the year-over-year increase would align with March's numbers. Core CPI is expected to increase by 0.3% month-over-month compared to 0.4% last month and by 5.5% year-over-year versus 5.6% last month. Inflation swaps predict a 5% year-over-year CPI increase, in line with analysts' expectations. The Cleveland Fed, on the other hand, anticipates a 5.2% increase in headline CPI year-over-year and a 5.6% increase in core CPI.

A Significant Drop In Inflation Expected

The CPI swaps market forecasts a significant drop in inflation between now and June, with the year-over-year rate of change falling to around 3% and remaining between 3 and 3.5% until the end of 2023. This makes the April number somewhat crucial, as the swaps market has generally been repricing inflation rates higher throughout the year. The last significant adjustment in inflation forecasts occurred in February.

Heading into 2023, the swaps market initially projected inflation to reach 2% by June 2023. However, that figure was consistently revised throughout January and February, with June's rate now trading at 1.5% higher than expected. The June inflation rate has stabilized and even begun to decrease slightly since mid-April. As a result, if the April data comes in higher than anticipated, it could lead to an upward revision of the inflation outlook for the next two months. Conversely, a miss could result in a downward revision of the inflation outlook.

Although headline CPI is significant, the core-CPI figure garners the most attention, particularly the super core-CPI reading, which excludes housing. This super core number has remained persistently above 5% since April 2022 and has been one of the key metrics the Fed focuses on. The Fed needs to see this number decline over the next several meetings to gain confidence that interest rates are adequately restrictive.

Another concern is that sticky measures of inflation remain pretty high as well, with the Atlanta Fed's 12-Month Sticky and Core-Sticky CPI indicators showing little to no improvement and still well above 6%.

Indeed, these measures of sticky and core inflation worry the Fed. While headline CPI is improving, these other inflation indicators are not. Although they have stopped rising, they haven't been falling either. The headline CPI may no longer be the best gauge of the Fed's thinking when determining appropriate policy rates.

Job Market Remains Too Hot

Another concern is the persistently tight job market, as evidenced by the drop in the unemployment rate to 3.4% in April from 3.5% in March, along with a 4.4% increase in wages—higher than the estimated 4.2% and the revised 4.3% March figure. The month-over-month increase in April wages was the largest in a year, reversing a steady trend of declining wage growth.

The accelerated wage growth and decreasing unemployment rates indicate that the job market is quite tight. Although the JOLTS data revealed a decline in job openings in March, the Indeed Job Posting Index suggests that this decrease may be temporary and will soon start to level off.

Supposing the JOLTS data stabilizes and the number of unemployed workers remains low. In that case, the ratio of job openings to unemployed workers will likely stay significantly elevated and well above pre-pandemic levels. This again implies that the demand for workers shows no signs of easing.

Mechanical Markets

If the job market remains tight and wage growth continues to be strong, one might wonder why the market rallied on Friday. The reason lies in the market's mechanics rather than investors being pleased with fewer jobs created than previously thought, as indicated by the revision in the non-farm payroll number.

One explanation is that short-dated volatility was elevated heading into the Fed meeting, as evidenced by the new VIX 1 Day Index. The VIX 1 Day Index rose sharply before Wednesday's FOMC meeting, climbing to 23 just minutes before the announcement. After the announcement, implied volatility dropped significantly. However, due to the data-dependent approach, the Fed now relies on, the VIX 1 Day Index did not fall entirely back to its lows. Instead, implied volatility increased again on Thursday afternoon, leading into the Jobs report. Once the Jobs report data was released on Friday morning, the VIX 1 Day Index plunged, dropping from above 20 at Thursday's close to below 13 by Friday's open. When implied volatility falls sharply, puts lose value, and as the market rallies, calls gain value. This results in options dealers having to buy the underlying stocks, ETFs, or index futures contracts, which helps push prices higher on the day.

On top of that, as the market traded higher by midday, it triggered a wave of same-day option traders to kick into high gear. SpotGamma shows that call deltas rose sharply on Friday afternoon, suggesting that call buying picked up steam around 1:15 PM, propelling the S&P 500 higher until 3 PM ET. At that point, call-buying activity subsided, and the index started to lose value, closing the day nearly 30 basis points off the highs.

One should get used to this type of market volatility, with the next significant day to watch being Wednesday's CPI report. Again, look for rising short-dated implied volatility, such as the VIX 1D index rising and the S&P 500 heading lower into Wednesday's CPI release, followed by a rally after the data is published, as the event risk is removed and the VIX 1D index drops. It is quite possible the actual data may not even matter, just like with the non-farm payroll number data.

As discussed during Friday's live Q&A session for members of my Seeking Alpha Investing Group, Reading Markets, with the Fed moving to a more data-dependent approach, each data point will take on greater importance and meaning, particularly heading into the June FOMC meeting. That meeting will reveal whether the Fed is genuinely pausing for the time being.

So while many may think that a Fed pause is a time to get bullish on the market, it is not because not only do the bulls remain trapped for many of the reasons laid out on April 20 , the move to a more data-dependent Fed means that things are only likely to get more volatile going forward, not less, and rising implied volatility is never good for stocks.

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