With CPI on deck, it’s going to be another big week for the markets. The CPI report has been a market-moving event in the past few months, and the October report comes out on Thursday, November 10.
Estimated May be too low
Consensus estimates may prove too low again for both core and core CPI. For the month of October, the CPI is estimated to have risen 7.9%, down from the September reading of 8.2%. Meanwhile, core CPI is estimated to have risen 6.5%, down from 6.6% in September. The problem is that the CPI and Core CPI have met or exceeded estimates in 10 of the past 12 months.
The Cleveland Fed expects inflation much higher than current consensus estimates. For the core CPI, the Cleveland Fed reports an annual increase of 8.1%; For the core CPI, it is estimated at 6.6%. If the Cleveland Fed is correct, analyst consensus estimates could be very low, at 0.2% for CPI and 0.1% for core CPI.
The problem is that the Cleveland Fed has historically underestimated actual CPI results. Over the last 19 months, the CPI has exceeded the Cleveland Fed’s estimate 16 times, and the core CPI is 14 times hotter than the Cleveland Fed’s estimate.
So if the consensus estimate for headline inflation is 7.9% and the Cleveland Fed is at 8.1%, there’s a good chance the headline CPI will come in much higher than the consensus and could be higher than the Cleveland Fed’s estimate.
Meanwhile, the consensus estimate for core CPI is 6.5%, and the Cleveland Fed estimates 6.6%. There’s a good chance it will beat the kernel as well.
Markets appear unprotected
So a higher than expected CPI will undoubtedly shock the markets and could create a lot of volatility. The difference between this month’s CPI reading and last month’s reading is that the market does not appear to be hedging when reading this month’s inflation data. So a hotter than expected CPI reading could have a much different result than last month’s drop of more than 2% at the open, followed by a “rapid rally” due to the implied volatility melting and short covering. In this case, the market appears to be overly hedged.
Going to last month’s CPI reading, the VIX was trading well above 30. This month the VIX is trading around 25. The only time this value has been lower since April was heading into the August CPI report when it was trading around 20 Perhaps because the market feels that the next FOMC meeting will not last for a month, and there is no need to worry about the effects of monetary policy. However, a higher-than-expected CPI is likely to increase hawkish rhetoric and may put a 75bp rate hike for December back on the table.
After a warmer-than-expected September reading, the market began anticipating a 75 basis point rate hike at the December meeting. But that prediction is starting to cool down around October 20.
However, a hotter than expected reading will likely bring the 75 basis points rate back to the table. Because the next meeting of the Federal Open Market Committee is scheduled for December 13-14, and the next CPI release date is scheduled for December 13.
The problem is that the Fed in Cleveland does not see a decline in CPI for November. Currently, the estimate for November is 8.1%. This means that a reading that comes in below expectations for November is unlikely to have a significant impact at that point because the Fed will want to see consecutive months of lower inflation before thinking differently about monetary policy.
This could indicate that after a higher-than-expected CPI reading for October, investors are more likely to scramble to buy long-term hedges than they currently have. Based on the current implied volatility term structure for the S&P 500, it appears that investors are hedging the risk of a higher-than-expected inflation reading but are doing so using the S&P 500 expiration date of November 10.
The implied volatility of the November 10 S&P 500 cash-out option expiration date is high relative to the volatility of dates before and after the CPI report. The market is currently only considering printing the actual CPI but not considering the potential implications of what comes after the report.
It is also likely to be the cause of the depression in VIX, where investors hedge for the day of risk but not after the real risk. This means that if the next CPI and FOMC report are out at the same time, investors may scramble to buy that protection 30 days from now, pushing the VIX higher.
If investors scramble to put hedges in place after a more-than-expected CPI report, it presents a potential headwind for stocks, as higher implied volatility drives stock prices lower.
At this point, the market may be ignoring the risks of the October CPI report this Thursday. And if the weather is hotter than expected, the downside risks for stock markets are significant, and the VIX is likely to rise much higher.
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