With the consumer price index on deck, it will be another big week for the markets. The CPI report has been an emotional event in the market over the past few months, and the October report arrives on Thursday, November 10.
May estimates be too low
Consensus estimates may again turn out to be too low for headline and core CPI. For October, the CPI is estimated to have risen 7.9%, down from September’s 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 to be much higher than current consensus estimates. For headline CPI, the Cleveland Fed shows a year-over-year increase of 8.1%; for the core CPI, he estimates 6.6%. If the Cleveland Fed is right, analysts’ consensus estimates could turn out to be too low and up to 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 past 19 months, the CPI has beaten Cleveland Fed estimates 16 times, and core CPI has turned hotter than Cleveland Fed estimates 14 times.
So if the consensus estimate for headline inflation is 7.9% and the Cleveland Fed is 8.1%, there is a good chance that headline CPI will be significantly higher than the consensus and could even be higher than the Cleveland Fed estimates.
Meanwhile, consensus estimates for core CPI are 6.5% and the Cleveland Fed estimates 6.6%; chances are the core is beating too.
Markets appear undercovered
So another hotter than expected CPI would undoubtedly be a shock 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 look as hedged ahead of this month’s inflation reading. Thus, a warmer than expected CPI could have a much different outcome than last month’s more than 2% drop at the open, followed by a “flash rally” due to the meltdown in implied volatility and the short cover; in this case, the market seems to have been over-hedged.
Going into 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 was lower since April was heading towards the August CPI report as it traded around 20. Perhaps because the market believes the next FOMC meeting is not a month away, there is no reason to s worry about the impact of monetary policy. However, a warmer than expected CPI will likely add to the hawkish rhetoric and could even put a 75 basis point rate hike back on the table for December.
Following September’s warmer-than-expected reading, the market began pricing in the odds of a 75 basis point rate hike at the December meeting. But that expectation began to cool around October 20.
However, a warmer-than-expected print would likely put the 75 bps rate discussion back on the table. Because the next FOMC meeting is scheduled for December 13-14, and the next CPI release date is scheduled for December 13.
The problem is that the Cleveland Fed does not see the November CPI falling. Currently, estimates for November are 8.1%. That means a lower-than-expected reading for November probably won’t have much influence at this point, as the Fed will want to see consecutive months of falling inflation rates before thinking differently about monetary policy.
This would suggest that following a warmer than expected October CPI, investors may scramble to buy longer-dated hedges than they have been doing now. Based on the current structure of the S&P 500’s implied volatility, it would appear that investors are hedging against the risk of higher-than-expected inflation, but using the S&P 500 expiration date of Nov. 10.
The implied volatility for the S&P 500 expiration date of November 10 for an at-the-money option is high relative to the volatility of the dates before and after the CPI report. The market is currently only thinking about the actual CPI print, but not thinking about the potential impacts of what comes after the report.
This is also potentially why the VIX is depressed, as investors hedge for the day of the risk but not after the risk. This means that if the next CPI and FOMC report are released at the same time, investors could rush to buy this protection in 30 days, pushing the VIX index higher.
If investors scramble to set up hedges after a hotter-than-expected CPI report, it will be a potential headwind for equities as rising implied volatility drives stock prices lower.
At this point, the market could ignore the risk of this October CPI report on Thursday. And if it were to get hotter than expected, the downside risk for stock markets is significant, and the VIX would likely rise much further.