Investors could be in for a big surprise if Wednesday’s consumer price index (CPI) comes in higher than expected, Gavekal Research warns.
Markets are currently expecting the Federal Reserve to cut rates significantly, but a rise in inflation could quickly overturn these expectations, leading to a “nasty shock,” Gavekal said.
They note that the futures market is currently pricing in a 100% certainty that rates will be cut on September 18, with a 50% chance of a more substantial 50 basis point cut.
In addition, interest rates are expected to be cut by 100 basis points by the end of 2024.
However, Gavekal warns that a rise in inflation could trigger a “sharp position adjustment,” forcing investors to rethink the Fed’s stance.
Gavekal said the debate within their team reflects the uncertainty in the broader market. Some analysts believe structural factors will push inflation above the Fed’s 2% target, while others argue that factors such as a contraction in the money supply and easing supply bottlenecks will rein in inflation.
“Yes, the July employment report showed that the labor market continues to cool. This implies that wage growth will continue to moderate, which reinforces the disinflation narrative. At the margin, it adds to the case for rate cuts. But a rise in inflation would undermine this case in the near term,” Gavekal said.
The Fed’s willingness to cut rates depends on the cooperation of inflation. If inflation surprises to the upside, the Fed can delay cuts, causing a rally in the U.S. dollar, higher bond yields and pressure on U.S. stocks, especially growth stocks.
Gavekal suggests that in the event of such inflation fears, the safest assets might be US dollar cash, T-bills and inflation-protected Treasuries. As Gavekal notes, with so much riding on the upcoming CPI release, investors may be wise to brace for potential volatility on Wednesday.
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