Make CPI Great Again
The Barclays Inflation Trading desk has an interesting banner. The next president means that inflation will make a stellar comeback. Treasury inflation protection (“TIPS”) is going to be great. The reality is that CPI could be breaking lower, making nominal Treasuries even greater.
Expectations are certainly priced for a good outcome at 8.30 am ET. The TIPS “break-evens”—the difference between real and nominal yields—are at the lowest in the range since 2022. The 2Y inflation expectation from TIPS is at 2.07%, close to hitting the target as gasoline prices remain low.
If it is up to expectations, including those of the NY Fed, Michigan, and Conference Board, headline CPI could dip sharply. The regression of CPI based on surveyed inflation expectations “predicts” that core CPI will fall to 3.3% compared to 3.4% estimated by economists (see Figure 1). That tenth of a percent lower core reading could be a “make or break” for stocks and bonds.
As discussed yesterday, (core) CPI appears more on the Fed’s minds. So, if the CPI regression is right, the one-tenth of a percent lower reading could add an extra 25 basis point cut to the pricing by year-end.
Yet, the rent component remains problematic. CPI rent consists of multi and single-family rental prices. There is a big difference in rent inflation for each whereas multi-family is in deflation due to rising (rental) supply), single family is sticky at 5% (Figure 2). That difference in rent inflation makes Powell hesitant and non-committal to having gained greater confidence.
Inflation must truly surprise the downside for the Fed to pick September as the kick-off to easing. Just like in 2015 when the speculative fever around the first hike reached heights by September, the Fed opted to be cautious and decided to give formal guidance in October for a December hike.
October 2015 became a massive risk-on month (S&P was up 8.5% in October 2016). Judging from Powell’s testimony, forward guidance on the first cut still needs three months of preparation, putting October in play for a massive risk on rally.
As for a surprise in CPI, as calculated by Bloomberg from 32 macro data points of over and under-estimated forecasts at multiple frequencies, the surprise could result in a 0.485% rise in the CPI index. The surprise index is cooling and seen in the Cleveland Fed NowCast of (headline) CPI (Figure 3).
For markets, the downside surprise is pivotal. But for the Fed that may not be enough. Still, option straddle for the S&P 500 options, and the 10-year Treasury imply a 1% for the equity index and 9 basis points in yield, the largest implied move since the October 2023 CPI release. Hence, CPI can make markets great.
Figure 1: Regression of CPI based on expectations (Y/Y%)
Source: BLS
Figure 2: Multi-family and single family rent inflation (Y/Y%)
Source: Zillow
Figure 3: CPI surprise (m/m%)
Source: Cleveland Fed, Bloomberg economics