(Bloomberg) — For the two years since the Federal Reserve began its aggressive fight against inflation, stock traders have been glued to their screens on days when the consumer price index was released.
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But things should be different on Wednesday, when the latest CPI is released. Why? Because, with inflation heading toward the Fed’s target and the central bank preparing to cut interest rates, the reading is less crucial for the stock market. Instead, what matters is the weakening jobs picture and whether the central bank can avoid a hard landing.
“The fundamental question for stock investors is whether the Fed waited too long to cut rates because recession risks are greater now than they were just two months ago,” said Eric Diton, president and CEO of Wealth Alliance. “Suddenly, inflation is no longer the big issue.”
The S&P 500 index is coming off its worst week since the Silicon Valley Bank Collapse in March 2023, when Big Tech stocks plunged, led by Nvidia Corp.’s 14% drop. Volatility also returned, with the Cboe Volatility Index, or VIX, rising from 15 on Aug. 30 to a high of nearly 24 on Sept. 6.
Options traders are betting there will be more of that, but less than the market expects on CPI day. As of Friday morning, they had priced in a 0.85% move in either direction for the S&P 500 on Wednesday. If realized, that would be one of the smallest one-day moves for CPI this year, data compiled by Piper Sandler show.
Meanwhile, traders had estimated an implied move of 1.1% for the S&P 500 ahead of Friday’s jobs report. That’s one of the highest this year in absolute terms and 83% above the average implied daily move in 2024, according to data compiled by Susquehanna International Group. And the broader equity benchmark managed to beat the forecast, falling 1.7%.
“Stocks have had a great run this year,” Diton said. “So why not take some profits?”
Attitude adjustment
Basically, market thinking has shifted now that rate cuts are seen as a given but the strength of the economy seems less certain.
Federal Reserve Chairman Jerome Powell all but declared victory in the fight against inflation during his remarks at the central bank’s symposium in Jackson Hole, Wyoming, on Aug. 23. Since then, more policymakers, including New York Fed President John Williams, Chicago Fed President Austan Goolsbee and Fed Governor Christopher Waller, have indicated that cuts are needed; it’s the size that’s up for debate.
Now the Fed is turning to the other side of its dual mandate: maintaining maximum employment. Friday’s jobs report showed nonfarm payrolls rose by 142,000 last month, putting the three-month average at the lowest level since mid-2020, according to the Bureau of Labor Statistics.
Ahead of the Fed’s Sept. 18 rate decision, swaps contracts are fully pricing in a reduction of at least a quarter-point. Meanwhile, implied moves ahead of major macroeconomic events tied to employment are gaining momentum, and equity volatility metrics such as skewness remain elevated as traders hedge against further downside risks to equities, according to data compiled by UBS Group AG.
“Skew is indicating that there is additional value in having downside protection for hedges,” said Rocky Fishman, founder of derivatives research firm Asym 500. “If things end up disappointing from a macro perspective, the potential downside for equities may be more volatile this time than previously thought.”
Investors have good reason to be more wary of employment numbers than inflation data right now. The S&P 500 posted its worst employment day since 2022 last month, falling 1.8% on Aug. 2, a Friday, and another 3% on Aug. 5 following a weak jobs report. Then, two weeks later, inflation numbers largely matched estimates, with the S&P 500 up just 0.4%, the smallest move for any CPI day since January.
High risk
Traders expect higher volatility in the S&P 500 now as out-of-the-money put options are in higher demand than out-of-the-money call options, UBS data shows. Commodity trading advisors, or CTAs, who take advantage of asset price momentum through long and short bets in the futures market, see little room to increase their positions from now on, according to UBS.
The VIX, which measures the implied volatility of benchmark U.S. stock futures via out-of-the-money options, is trading around 20%, a level that doesn’t necessarily signal outright danger in and of itself, but it’s 52% above its average reading this year, and the volatility curve implies elevated risk for the months ahead.
With Fed officials in a quiet period ahead of their next monetary policy decision, there won’t be any comments before Sept. 18. However, the central bank’s latest Beige Book, which compiles information from business contacts in each of its 12 districts, found that business contacts are more concerned about slowing growth than inflation. Still, there were no mentions of a “recession” and just 10 references to “inflation” — a low for 2024, according to DataTrek Research.
While consensus expectations are for the U.S. economy to remain robust, the Atlanta Fed’s GDPNow model shows some slowdown, with third-quarter real GDP growth projected to rise to a 2.1% annual rate, down from about 3% a few weeks ago.
It’s yet another sign that the Fed needs to cut rates before it’s too late to avoid a recession. If it doesn’t, investors who push stocks higher on the expectation that policymakers will soon cut borrowing costs may be forced to grapple with the old cliché of “Be careful what you wish for.”
That’s particularly true if fears mount in the stock market that central bankers are failing to adequately combat an economic slowdown that will eventually hurt corporate profits, according to Wealth Alliance’s Diton.
“Now everyone is looking at every piece of data on the economy and employment,” he said. “If the data remains weak, there will continue to be more sales.”
–With the help of Elena Popina.
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