The US Consumer Price Index (CPI) report is the main highlight for markets this week. Recent weak economic data has led traders to think there might be a rate cut in September, as Federal Reserve officials are becoming more cautious. If inflation surpasses expectations, concerns may grow. The risk of stagflation is increasing, causing worry among market participants.

Inflation Expectations for July

Analysts expect a 0.2% monthly rise in headline inflation for July, down from 0.3% in June. However, the annual inflation rate is projected to rise to 2.8%, up from 2.7% previously. Core inflation is expected to rise by 0.3% monthly, compared to 0.2% in June. Year-over-year, core inflation is estimated to increase to 3.0%, up from 2.9%. Core inflation numbers are crucial, but the specifics of the report matter too. It’s important to watch if businesses pass on higher tariffs to consumers, as this could pose challenges for the Federal Reserve. Policymakers might reference past approaches, calling inflation “transitory” to justify potential rate cuts later in the year, arguing that tariffs could temporarily inflate prices. Still, if inflation persists, it will complicate the Federal Reserve’s choices and keep markets on edge as September approaches. With the important US CPI report coming this week, we anticipate a strong market reaction. Current pricing on CME Fed Funds futures indicates a 65% chance of a rate cut in September. This is influenced by recent weak data, including a Q2 GDP growth of just 0.9% and an increase in the unemployment rate to 4.2%.

Hot Inflation Risks

A surprise rise in inflation could derail hopes for a rate cut and raise concerns about stagflation. This uncertainty has already pushed the CBOE Volatility Index (VIX), a measure of market fear, from around 13 earlier this year to over 18. We are watching for any signs of a further increase. Expectations are for the annual inflation rate to reach 2.8%, with core inflation rising to 3.0%. A figure above these expectations would challenge the Federal Reserve’s recent dovish stance, indicating that price pressures may be returning even as economic growth slows. Given this uncertain outlook, strategies that benefit from significant price swings in either direction appear promising. For instance, options strangles on the S&P 500 or Nasdaq-100 indices could effectively capitalize on the volatility surrounding the CPI report. These trades can profit whether the market rises on a soft report or declines on a hotter one. We are also closely monitoring the interest rate derivatives market, especially options on Treasury note futures. A CPI report that exceeds expectations could lead to a spike in yields, undermining the narrative of an impending rate cut. Traders are preparing for this possible shock to bond prices. The Fed’s strategy of labeling inflation as “transitory” due to tariffs brings back uncomfortable memories. Back in 2021, the Fed used similar language as inflation surged to 40-year highs, which resulted in aggressive rate hikes in 2022 and 2023. Market tolerance for this narrative is likely low. Any hints in the CPI report that businesses are passing tariff costs onto consumers will be a significant warning sign. This type of inflation is challenging for the Fed to manage with monetary policy, placing policymakers in a tough spot ahead of their September meeting. Create your live VT Markets account and start trading now.

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