Prelude to a Potentially Tumultuous Week

There are days when the markets seem to be biding their time before something bigger. When we consider how many potentially market-moving events are on tap for the days ahead, today may be one of those sessions that are a prelude to something bigger. Unfortunately for market participants, this could be one of those times when there isn’t a great consensus about what to expect and how to prepare for the eventualities.

The key event is tomorrow morning’s Consumer Price Index (CPI) release. The consensus is for big numbers: a 4.9% increase in annual CPI growth and a +0.4% rise in monthly index ex-food and energy. And the expectations for Wednesday’s Producer Price Index (PPI) release are even larger: +6.7% and +0.5% on the same basis. Of course, the real question is not what the numbers will be, but how the markets will react. For one thing, we have seen dramatic increases in grain and energy commodity prices, so it is possible that the core rate can diverge from the headline number even more than anticipated. And I don’t think there is much clarity about how the markets – especially the bond market – will react if the numbers beat or miss. 

If the numbers are lower than expected, do investors question growth prospects or do they laud the idea of a Goldilocks economy? If the numbers are higher, does that re-spark inflationary fears or will we get a conciliatory narrative that we are seeing peak inflation that can only shrink? In either case, might the markets be able to kick the can down the road by saying that the Fed prefers to look at a different inflationary gauge altogether (the PCE price deflator)?

Quite frankly, the outcome will have as much to do with the market’s psychology that morning as anything else.  Bond rates plunged recently, but many experts attribute that to short-covering rather than a significant change in the perceptions about growth and inflation. Lower rates on longer-dated fixed income have been used as a valuation prop for the mega-cap technology stocks that make up the majority of the Nasdaq 100 Index (NDX) and a significant percentage of the S&P 500 Index (SPX). Investors seem to be able to put a gloss onto mega-cap tech stocks no matter what, and it is hard for major indices to fall if those stocks rally. Yet if bond yields move sharply higher, those stocks could actually see some pressure.

Federal Reserve Chair Powell is due to testify in Congress on Wednesday, so much of the reaction to the inflation numbers will be based upon his comments on growth and inflation. How might Mr. Powell interpret the numbers in light of the stated goals of full employment and sustainable 2% inflation? Will the language shift from “transitory”?Some slight changes in verbiage from the Fed chair could mean much more to the markets than the hard data that drives the Fed’s decisions.

Speaking of statistics, earnings season returns on Tuesday with JP Morgan (JPM) as the new harbinger.[i]Goldman Sachs (GS) and Pepsi (PEP) also report on Tuesday, with most of the major banks following along later this week. Unfortunately, I think big banks are a lousy bellwether for earnings and the market’s reaction to them. In theory, universal banks have the best view of trends in the consumer and corporate sectors. In reality, those insights are often limited to some comments in the conference call. In practice, banks are more dependent upon the shape of the yield curve and their trading divisions for quarterly results – and analysts tend to be dismissive of solid trading results as being one-offs no matter how consistent they might be.[ii]

Finally, Friday brings a monthly expiration. The CBOE Volatility Index (VIX) has been quite volatile over the past few sessions, with traders flipping between sanguine to briefly nervous on Thursday to “nothing to see here” on Friday. This morning, the pre-opening dip in ES futures led to a brief rise in VIX that evaporated when the indices regained their footing. While VIX remains relatively stable over the longer term, it is important to remember how quickly VIX can shoot higher on nervous days. Most investors have since ignored last Thursday’s dip as a one-day hiccup, but it was quite meaningful to volatility traders. 

Intraday VIX Index, Past 5 Days

(Click on image to enlarge)

Source: Bloomberg

That should offer a lesson to investors. Between economic releases, Fed speech, earnings, and expiration, there is ample opportunity for volatility in the week ahead. Might animal spirits be strong enough to overlook any potholes in the current investment climate? Sure, that’s quite possible. But more than most weeks, this one offers plenty of opportunities for surprises. All starting tomorrow.

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[i] As a side note –it’s been interesting how that kickoff signal has shifted over the years from Motorola to Alcoa to JPM over the years based on their relative timing and importance to the market narrative

[ii] Do I sound bitter about that? As someone who traded for years at public companies, I have always resented how analysts seem to devalue trading profits. Trading dollars are just as real as any other dollars!