With the consumer price index on the table, it will be another big week for the markets. The CPI report has been a market event for the past few months, and the October report is due on Thursday, November 10.
May estimates Be very rare
Consensus estimates for both headline and core CPI may again prove too low. For October, the CPI is estimated to have increased by 7.9%, from September’s reading of 8.2%. Meanwhile, the core CPI is estimated to have increased by 6.5%, down from 6.6% in September. The problem is that CPI and core CPI have missed estimates in 10 of the last 12 months.
The Cleveland Fed is forecasting much higher inflation than current consensus estimates. For headline CPI, the Cleveland Fed shows an 8.1% year-over-year increase; for the core CPI, it estimates 6.6%. If the Cleveland Fed is right, analysts’ consensus estimates may prove too low, at around 0.2% for CPI and 0.1% for core CPI.
The problem is that the Cleveland Fed has historically underestimated the actual CPI results. Over the last 19 months, the CPI beat the Cleveland Fed’s estimates 16 times, and the core CPI was 14 times warmer than the Cleveland Fed’s estimates.
So if consensus estimates for headline inflation are 7.9% and the Cleveland Fed is at 8.1%, there is a good chance that headline CPI will be significantly higher than consensus and possibly even higher than the Cleveland Fed estimates.
Meanwhile, consensus estimates for core CPI are 6.5%, and the Cleveland Fed estimates 6.6%; there is a good chance that the core is also beating.
Markets Seem Under Hedged
So another warmer-than-expected CPI would certainly be a shocker to 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 doesn’t appear to be holding back on this month’s inflation reading. So a warmer-than-expected CPI could have a very different outcome than last month’s more than 2% decline at the open, followed by a “lightning rally” due to the dilution of perceived volatility and short-covering; in that case, the market appears to be over-hedged.
At 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, when it was trading around 20, was going into the August CPI report. Perhaps because the market feels that the next FOMC meeting is not a month away, there is no need to worry about the effects of monetary policy. However, a warmer than expected CPI will likely increase hawkish rhetoric and could even put a 75 bps rate hike back on the table for December.
Following a warmer-than-expected September reading, the market began pricing in a 75 bps rate hike at the December meeting. But that hope started on October 20.
However, a hotter-than-expected print will bring the debate back to the table for a rate of 75 bps. Because the next FOMC meeting is scheduled for December 13th and 14th, and the next CPI release date is scheduled for December 13th.
The problem is that the Cleveland Fed doesn’t see the November CPI falling. Currently, estimates for November are 8.1%. This means that a reading that comes in below expectations for November is unlikely to have much impact at that point as the Fed will want to see the next few months of falling inflation rates before thinking differently about monetary policy.
That would suggest that following the warmer-than-expected October CPI, investors are likely to try to buy longer-term assets than they have done so far. Based on the S&P 500’s current volatility term structure, it appears that investors are hedging the risk of a warmer-than-expected inflation reading but doing so using the S&P 500’s November 10 expiration date.
For a November 10 out-of-the-money option on the S&P 500 for an out-of-the-money option increases based on the change in dates before and after the CPI report. The market is now only thinking about the actual CPI print but not about the potential effects that come after the report.
This is also potentially why the VIX is depressed, because investors are holding the risk for the day but not after the actual risk. This means that if the next CPI report and the FOMC are at the same time, investors may buy that protection 30 days later, driving up the VIX index.
If investors try to get behind a warmer-than-expected CPI report, that’s a potential downside for stocks, as rising perceived volatility lowers equity prices.
At this point, the market may be weighing in on the risk of this October CPI report this Thursday. And if it’s hotter than expected, the downside risk to equity markets is significant, and the VIX could rise significantly.