In theory, interpreting data releases as important and high profile as this morning’s CPI numbers should be simple enough. After all, they measure something concrete — actual price rises in the economy in this case — and the standard interpretation is straightforward. Higher than expected means a greater chance of more, bigger, or faster interest rate hikes, while lower would suggest that maybe Jay Powell was right all along in that inflation was transitory, albeit somewhat slow in actually transiting, and the rate hikes may not be as disruptive as feared.
In markets, though, nothing is that simple.
This morning’s monthly and annual numbers were higher than expected in both comprehensive and core inflation and yet the major indices moved higher immediately following the release.
Figure 1: S&P 500 Futures ES 1 Minute Chart
There are three possible explanations for that, and which is the most accurate is important in terms of what the move means for the longer term.
The first possible explanation is that it is a result of accumulated market positioning going into the release. That would make sense after a week or so of down days, when traders would have taken short positions. If that were the case, anything other than a really disastrous inflation read would prompt a short-term rally as those traders bought index futures to square up. If that is what happened, the pullback in ES that came after five minutes or so will prove to be the real move, and we will be back to weakness in all the major indices for a while.
The second reason for that reaction would be that there was some kind of “whisper number” out there, an unofficial expectation for a much higher print. In that case, the move after the numbers would be essentially a relief rally. Again, though, it would be extremely short-lived. “Not as bad as feared” can prompt buying but it is still bad, and the danger of dramatic, aggressive moves by the Fed that could choke growth would be increased.
The third possible reason for the move up is the most intriguing. It could be that the other two reasons are true to some extent, but that the real force underpinning the move up on a “miss” is something with much longer-term implications: What if the move up happened because the bad news about interest rate hikes and even the worst-case scenario is already fully priced in at current levels?
On the surface, that makes no sense. There has been some rotation out of growth names in the early trading in 2022, but all three major indices are still just a few percentage points off their all-time highs. Given the known negative impact of rate hikes, the standard interpretation of that is that so far, the market has failed to price in those impending changes. Until now, that has definitely been my view, but this morning’s reaction to the data raises another possibility.
Maybe, without the threat of a policy change by the Fed, we would be significantly higher than even these lofty levels. Maybe the fact that the S&P isn’t ten or fifteen percent above the all time high is, in fact, an adjustment to what is to come this year. If that is what we are seeing, a lot of the general assumptions about the rest of the year are called into question. Three or even four incremental rate hikes could be made without any lasting negative impact on the market, and any sign that inflation has peaked early in the year would create a strong move up.
It is an intriguing idea, and there is some evidence to suggest that it might be true. At first, inflation is usually caused by economic strength. Unemployment is low and growth is decent, while corporate profits keep climbing. Over the next few weeks, as Q4 earnings season gets going, we will find out if that trend in profits is still intact. If it is, and if the Fed’s reaction to inflation is already priced in, a really strong Q1 for stocks after a wobbly start would be the logical result.
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