Tomorrow’s CPI Release has Serious Market Implications

As we’ve previously discussed (and a topic that everyone has been hearing about a lot), the United States and the world have been dealing with severe inflation for the last year or so. This is mostly a result of massive stimulus pumped into the economy during the pandemic, including artificially low interest rates, creating certain asset bubbles, while supply and production slowed due to people not working. While all indications are that inflation in the US has peaked and is coming down, the markets are anxiously awaiting the December CPI (consumer price index) number tomorrow, a number on which short-term stock and bond market fluctuations, as well as mortgage rates, will hinge.

The current annual CPI is 7.1% and tomorrow’s release of the December 2022 CPI will be replacing the December ’21 monthly number of 0.6%. The market expects the updated annual CPI inflation number to be 6.5%. This means replacing a 0.6% increase with a flat number. This leaves little margin for error. If we get a monthly number much higher than 0.0%, the stock market will drop precipitously and yields for shorter term bonds will increase. This is due to the fact that a higher than expected inflation reading will cause the Federal Reserve to continue more aggressive raising of the FED funds rate, and likely delaying a pause or rate cut, which will continue to slow the economy.

The FED has been talking tough for a while about continuing to raise rates and keeping them high for a while, but the market expects that they will follow the inflation data and pause rate hikes when it is clear that inflation is under control (or at least wait for their work to fully take effect following the meeting this week). The data released tomorrow will likely determine whether the FED hikes rates by .25% or .50% at next week’s meeting, however the status of future rate hikes and cuts are of more concern to the markets that have already priced in next week’s hikes.

Short term rates and economic growth will be impacted by the FED hikes, but a larger rate hike might have the opposite effect of lowering on long term (10 and 30 year) treasury yields, to which mortgage rates are more closely correlated. Therefore, if CPI is higher than expected tomorrow, the stock market could crash and the yield curve could become even more inverted as short term yields rise and long term yields drop due to the expectation that continued, more aggressive, rate hikes will get inflation under control in the long run and potentially lead to a severe recession, which is deflationary. Either way, mortgage interest rates could drop, and they could drop further with a higher CPI reading in a “bad news is good news” sort of scenario, which happened when the markets reacted favorably to lower than expected wage increases last week.

My prediction, December’s CPI will be lower than expected (-0.1) bringing the yearly CPI to 6.4%, the stock market will rally in the short term, short term bond yields will drop sharply, and long term bond yields will drop slightly. This seems to be likely due to deflationary conditions recently for energy, lumber and materials, used cars, and shelter. The FED will hike .25% next week, but will continue to talk tough. Mortgage rates will continue their slow decline towards the 4.0%’s by the summer.