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The hotter-than-expected CPI report has driven significant market reactions, with the U.S. dollar strengthening and S&P 500 futures dropping more than 1% and to only reverse at NY open. However, the question remains whether this move will extend further.
Why the Move May Not Extend
Residual Seasonality and One-Off Factors:
Discussions around "residual seasonality" in CPI data are gaining traction. This concept suggests that certain seasonal patterns persist even after adjustments, potentially overstating inflation during specific periods.
Additionally, temporary factors like spikes in egg prices and disruptions from California fires may have artificially elevated the CPI reading. These anomalies are unlikely to sustain upward pressure on inflation.
Fed Rate Expectations:
Market expectations for Federal Reserve rate cuts have adjusted slightly, with pricing for cuts in 2025 falling from 40 basis points to 30 basis points. This aligns with the Fed's guidance that rate cuts will likely be gradual and mechanical as inflation approaches the 2% target. January's hotter inflation data has reduced the likelihood of imminent rate cuts but does not suggest a worsening inflation trend.
Importantly, the Fed's focus remains on disinflationary progress in core services, which showed improvement in the latest data.
Housing Market Dynamics:
Housing is a significant component of CPI, and current trends indicate disinflationary pressures from this sector. U.S. home prices are stabilizing, and rents are declining in many areas, which will likely weigh on CPI throughout the year.
These factors suggest that inflation is not accelerating but rather moderating over time.
Economic Fundamentals:
Broader economic indicators do not point to an accelerating economy. Retail sales data, expected to show a slight decline of 0.1% month-over-month, could reinforce the view that consumer demand is softening.
The market's current focus is less on fundamentals like inflation and more on other drivers such as geopolitical risks, fiscal policies (e.g., potential tax cuts), and tariff negotiations.
Potential Risks
Tariff Uncertainty:
Tariffs remain a wildcard that could disrupt inflation dynamics. If trade tensions escalate, import costs could rise, adding upward pressure to prices.
However, political appetite for a tariff fight may wane given the current economic backdrop, reducing this risk.
Market Sentiment Not Driven by Fundamentals:
Recent market moves have been influenced more by sentiment and positioning than fundamentals. Traders were already bracing for a hot CPI report, and much of the reaction may already be priced in.
Renewed inflation fears are unlikely to dominate the narrative unless subsequent data surprises significantly to the upside.