Inflation traders are positioning for a slightly bigger-than-expected blip higher in the annual headline rate of Thursday’s consumer price report for December, one that shouldn’t matter much to the overall downward trajectory of price gains this year.
As of Tuesday, derivatives-like instruments known as fixings were trading around levels that imply December’s annual headline CPI rate will come in at 3.3%, up from 3.1% in November and slightly above the 3.2% level expected by economists. Fixings traders are made up of some of the financial market’s best minds on inflation, with a record of having presaged the 2021-2022 run-up in prices.
Two factors likely to contribute to a somewhat higher annual headline CPI inflation rate in December relative to November are airfares and the cost of vehicle insurance, which are expected to show short-lived bumps, said trader Gang Hu of New York hedge fund WinShore Capital Partners.
Still, there’s “nothing to challenge” the market’s overall thinking that U.S. inflation is set to fall toward the Federal Reserve’s 2% target throughout this year — buttressing the case for 2024 rate cuts by the central bank.
“It’s the first inflation report of the year and investors are going to definitely pay attention to it,” said economist Lauren Henderson of Stifel, Nicolaus & Co. in Chicago. “It also comes ahead of the FOMC [Federal Open Market Committee] rate decision later this month, so Fed officials themselves will be looking at it.”
If the report comes in as expected, “that could solidify the Fed’s expectations for three rate cuts this year,” she said via phone on Tuesday. However, “if we see some unexpected upside, that could dial back investors’ expectations for rate cuts as soon as March. And rate cuts could begin in the second half of the year.”
Fed officials are trying to temper the market’s expectations for as many as six or seven rate cuts this year, starting in March. On Monday, Atlanta Fed President Raphael Bostic said two quarter-point rate cuts are likely to be needed by year-end, versus the three cuts telegraphed by policymakers in December. Meanwhile, Fed Gov. Michelle Bowman said that while inflation might keep falling without more rate hikes, easing financial conditions could cause a reacceleration of price gains.
Accurately predicting the path of inflation matters because of the widespread view that it is in the final mile. However, financial markets continue to price in far more rate cuts than Fed officials have signaled — creating the potential need to pull back on those expectations for the fed funds rate target, which currently sits between 5.25%-5.5%.
One loophole in the forecasts of fixings’ traders is the absence of payrolls data like December’s, which showed an unexpectedly solid 216,000 new jobs created and stronger-than-expected wage growth. Wages are “the one remaining ember that could reignite inflation,” said Brent Schutte, chief investment officer of Milwaukee-based Northwestern Mutual Wealth Management Co., which oversaw $255.7 billion as of the end of September.
Read: Financial markets may be overlooking ‘one remaining ember’ that could reignite inflation
Fixings traders “don’t know how or find it hard to make a connection between payrolls and CPI,” Hu said via phone. “The relationship between payrolls and CPI changes over time and is unstable. Therefore, traders lean toward something more concrete like car insurance, oil prices, or owners’ equivalent rent for the lack of anything else.”
Traders expect the monthly core CPI rate, which strips out food and energy, to come in at 0.3% for December, according to Hu, citing his own personal calculations. That’s in line with economists’ expectations and unchanged from the prior month.
In addition, the market’s implied level for the core CPI rate is 2.5% over the next 12 months, including December’s data, he said.
On Tuesday, Treasury yields ended little changed ahead of December’s CPI report, with the benchmark 10-year rate
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staying above 4%. U.S. stocks
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closed mostly lower.
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