With the CPI Print Set to Test the Market, Traders Bet on Wild Swings

As Wall Street nears the end of a tumultuous summer, the focus has shifted to this week’s consumer prices report. Investors and traders alike are hoping that the report will provide the Federal Reserve with the necessary justification to start cutting interest rates during its next meeting in September. However, in the meantime, the market is bracing for more volatility.

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Last week’s market activity saw wild fluctuations that pushed the Cboe Volatility Index (VIX), which measures the magnitude of price swings in the S&P 500 Index, to levels not observed since the peak of the pandemic in 2020. According to Citigroup Inc., traders are now positioning for a potential 1.2% movement in either direction for the S&P 500 on Wednesday when the consumer price index (CPI) report is released. If this prediction holds through Tuesday’s close, it would align with the expected moves for August 23rd, when Federal Reserve Chair Jerome Powell is set to speak at the Jackson Hole economic symposium, and August 29th, the day after Nvidia Corp.’s earnings report.

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“The options market isn’t signaling an all-clear for stocks just yet,” said Rocky Fishman, founder of derivatives analysis firm Asym 500. He noted that while high volatility historically presents a good opportunity to buy equities, this strategy may have already played out to some extent, making the CPI report a crucial catalyst.

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Despite the S&P 500 rebounding from a 3% plunge on Monday — a drop tied to the unwinding of a massive yen-fueled carry trade that rattled global bond markets — and ending the week relatively flat, options traders remain skeptical of the recovery.

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One notable sign of this skepticism is the rising cost of protective contracts. Data compiled by Bloomberg reveals that contracts protecting against a 10% decline in the SPDR S&P 500 ETF Trust (SPY), the largest exchange-traded fund tracking the broad equities index, are currently priced at their highest level since October. These contracts are now twice as expensive as those profiting from a 10% rally, indicating that traders are more concerned about potential downside risks.

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The uncertainty extends beyond the CPI report. Traders are also questioning whether the implied market moves will increase after Powell’s speech, given that he might outline plans for rate cuts in the near future. Powell’s upcoming message could offer insights into how many rate cuts investors can expect over the next year, especially after his indication in late July that the Federal Reserve might begin reducing borrowing costs as early as September.

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“We’re at a point where bad economic news is now seen as good news because it could force the Fed to pivot,” said Thomas Urano, co-chief investment officer and managing director at Sage Advisory in Austin, Texas. “But if economic data continues to weaken, it could disappoint stock investors and lead to more significant market swings.”

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Although the yield on the U.S. 10-year Treasury notes has returned to pre-jobs report levels, erasing most of the recent steep declines, the broader economic picture remains murky. The rise in unemployment for the fourth consecutive month has raised concerns that the Federal Reserve’s aggressive monetary tightening might be stifling the economy. As a result, labor market data, including the upcoming August jobs report, will be just as critical for traders as the inflation figures. The Federal Reserve has increasingly emphasized the importance of both full employment and price stability, with the unemployment rate recently rising to 4.3%, significantly above the Fed’s year-end forecast.

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Federal Reserve officials are keenly aware of the need to avoid a significant downturn in the labor market. “The labor market is slowing, and it is crucial that we don’t let it slow so much that it tips into a downturn,” said Mary Daly, President of the Federal Reserve Bank of San Francisco, on August 5th.

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Adding to the uncertainty is the recent normalization of the yield curve, with the gap between two-year and 10-year Treasury yields returning to normal levels for the first time in two years. This development, which has historically occurred before previous recessions, was short-lived as the curve quickly inverted again. Despite the temporary normalization, the economic signals remain mixed, with the pandemic having disrupted traditional business activity.

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In the stock market, lingering fears of economic growth risks have led to a reversal of momentum trades and a shift towards defensive leadership, according to Thomas Salopek, head of cross-asset strategy at JPMorgan Chase & Co. He anticipates further pain and sharp swings for stocks in the near future. Over the past ten sessions, the S&P 500 has experienced an average intraday movement of 2% in either direction, the highest since November 2022, according to data.

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This heightened volatility explains why traders are bracing for a significant market reaction to Wednesday’s inflation report. The core CPI, which excludes volatile food and energy prices, is projected to increase by 0.2% month over month and 3.2% year over year. This figure is close to the Federal Reserve’s 2% target. However, if the report deviates significantly from expectations, it could prompt traders to reassess their outlook, potentially triggering another round of market turbulence.

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“If the Fed cuts rates dramatically due to a slowing economy, it historically hasn’t been good for stock returns,” said Brooke May, managing partner at Evans May Wealth. Her firm is currently investing in Big Tech stocks but remains cautious about the near-term outlook. “The economy isn’t as bad as people think. I expect more volatility and wouldn’t be surprised to see more downside for stocks in the coming weeks.”

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