Currency Volatility: Are Markets Underpricing CPI Volatility Risk?

WHAT DOES TODAY’S CPI RELEASE MEAN FOR MARKETS?

The main focus for market participants will be the release of the latest US inflation figures. Expectations are for a jump to 2.5% from 1.7%, which would mark the highest reading since January 2020. A reading above 2.5% would likely see inflation at mid-2018 levels, where the headline rate peaked at 2.9%. While the core figures are expected to show a slight lift to 1.5% from 1.3%. In theory, a spike in inflation should not come as a surprise to markets given that it has been well documented at length that base effects will prompt a jump in CPI. That said, with the Federal Reserve remaining adamant that they will look through a Summer inflation spike as they expect inflation will be transitory, that should mean today’s inflation read has little policy implications and thus have a rather muted impact on markets. As Fed’s Bullard stated yesterday, inflation risks won’t be clear until later this year and with the Fed’s view that inflation will be transitory, this will not be completely known until Autumn.

US CPI EXPECTED TO HIT 2020 HIGH ON BASE EFFECTS

Currency Volatility: Are Markets Underpricing CPI Volatility Risk?

ARE OPTION MARKETS UNDERPRICING CPI RISK?

Taking a look at FX implied option volatility, the EUR/USD implied move is at 34pips (+/-0.29%), which would back up my view that in theory, markets should see a muted reaction to the CPI reading given that an inflation spike is expected. Although, I do believe that with markets very much skewed to the upside on the inflation front, the reaction to a miss on expectations vs a beat is likely to be larger (of course, this is relative to the deviation away from the expected figure). That being said, it is important to note the current market narrative and fixation around inflation, which may suggest that option markets are at risk of underpricing today’s data, which in this case could see an initial overreaction to the CPI release.

Currency Volatility: Are Markets Underpricing CPI Volatility Risk?

Source: Refinitiv

The table below shows the reaction to US CPI last month across multiple asset classes, where the headline rate printed in-line with expectations, while the core figures fell short of expectations. Subsequently, the S&P 500 moved higher in response as a miss on expectations dampens tightening expectations, similarly gold also jumped amid the pullback in both US yields and the USD, while the high-beta AUD tracked risk sentiment higher.

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