Article / 11 October 2017 at 22:48 GMT

Beware fake news in the US inflation report

Managing Director / Technical Research Limited
New Zealand
  • Financial markets find themselves in the best of all possible worlds 
  • Friday’s US inflation report will be a key test 
  • OIS curves have global rate hikes priced in for this time next year

By Max McKegg

It was the best of times; it was the worst of times. That might be a preliminary assessment of 2017, depending on whether you are an investor or a very short-term trader.

For the investor, The Economist magazine summed up the situation in a recent front cover headline: “The bull market in everything”.

As shown in the chart below, volatility has dropped to a 40-year low as the US stock market continues to push into record territory. High returns with low risk: the best of all possible worlds. Bonds might not be providing the same high returns of late but prices remain close to all-time highs while volatility numbers drop. The correlation between US Treasury bond yields and the major USD crosses means volatility in the FX markets is low as well. 

The best of times for investors then, but the worst of times for traders. Volatility is their lifeblood.

Stocks vs bonds volatility

The economic background is supporting the performance of financial markets. In the major economies, GDP growth is running above potential, absorbing spare capacity and pulling down unemployment rates. This would bring a smile to face of central bankers but for one glaring omission: the much-delayed achievement of 2% inflation.

Cooler heads will ignore the hurricane-affected headline CPI result. Photo: Shutterstock 

So how should we trade the CPI inflation report out of the US this Friday?

There’s a good chance it will contain #Fake News. The headline rate will likely come in above the Federal Reserve’s objective; perhaps as high as 2.3% year-on-year. If a number like that flashes across the screens, the knee-jerk reaction will be to bid USD and offer US bonds. But cooler heads will ignore the headline result due to the impact the recent hurricanes had on gasoline prices. 

Instead they will look at the core result, which excludes energy price effects. As shown in the chart below, the core CPI is currently languishing at 1.7% year-on-year as at the end of August. The September number would need to come in at 1.9% or better to justify a sustained bullish market reaction.


The minutes of the September 19-20 meeting of the Federal Open Market Committee, released on Wednesday, showed that members are as much in the dark about the inflation outlook as everyone else: “Many participants expressed concern that the low inflation readings this year might reflect not only transitory factors, but also the influence of developments that could prove more persistent.” Certainly any jump in the headline rate in Friday’s update will be put into the “transitory” category.

Nevertheless, markets expect the committee to raise the fed funds rate by 25 basis points on December 14 and announce the start of a quantitative tightening program. The direction of December fed funds futures contract suggests the probability of a hike then is better than 80%, as illustrated in this chart:

Fed funds Dec 2017 (click to enlarge)
 Source: Metastock

Meanwhile the FOMC’s counterparts at the European Central Bank and Bank of Japan continue to expand their own balance sheets. When it comes to inflation, they want to see the whites of its eyes before taking a foot off the accelerator.

Central banks' balance sheet
Source: Bloomberg

The chart below sums up the situation in a global context. The Overnight Index Swap (OIS) curve in the UK has steepened, now pricing in an 80% probability of a rate hike by the Bank of England in November. The Australian and New Zealand curves are flatter, both pricing in a 25 basis point rate hike around this time next year. The euro curve also turns up around then, but only by 10 basis points. The Japanese curve, not shown here, flatlines into perpetuity.

The long end of US curve hasn’t changed much in recent weeks. The fed funds rate tops out around 1.75%, well below where the FOMC’s dot plot would have it.


Source: Bank of New Zealand 

Global economic growth is returning to trend but inflation remains a missing piece in the jigsaw. Central bankers will continue to provide financial market support until that gap is filled. Confident in this support, investors have created a low-risk bull market in everything. The US Federal Reserve is talking the talk about draining the punch bowl but they are reluctant to walk the walk. Friday’s CPI report might give them confidence to up the ante.

– Edited by Susan McDonald

Max McKegg is is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade, then click here to follow him.
Patto Patto
Nice work Max..... not much volatility in the FX majors but we should get some action in NZDUSD when the new government is announced
Max McKegg Max McKegg
action aplenty!
Stefan Vegh Stefan Vegh
Very nice overview Max!
Max McKegg Max McKegg
thanks Stefan


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