CPI, FOMC to Drive Market Volatility

Markets may experience high volatility tomorrow due to key CPI data released just hours before the FOMC rate decision is made public.

Dual Catalysts for Volatility

Until last Friday, markets had settled on expecting an interest rate cut in September as inflation continued trending lower. However, the unexpectedly strong May employment report showed accelerating average hourly wages diverging from inflation. Wages are understood to pull up consumer prices and sustain strong demand, providing hesitancy for the Federal Reserve to cut rates quickly. This left futures markets pricing a practically even chance of a September cut, with a majority now believing only one cut this year.

 To reverse this trend would require a solid sign that inflation is declining. The release of CPI figures tomorrow could provide this, but coming so close to the conclusion of the FOMC meeting gives markets very little time to adjust expectations. This could lead to an exaggerated reaction or whipsaw move in markets. Options traders forecast as much as a 1.3% move in the S&P 500, the largest implied volatility ahead of a Fed meeting since mid-last year - when markets expected a policy shift away from hiking.

What Will Change?

For May, US and core inflation are expected to remain unchanged at 3.4% and 3.6%, respectively. This sets the stage for a strong market reaction given that a slight difference, either way, could confirm inflation is decreasing or show it has stalled and may require more pressure to decrease. It is important to note that while consensus indicates the following Fed action will be a cut, some FOMC members still say an increase is not off the table.

The Fed meets on Tuesday and will deliberate monetary policy in light of the upcoming inflation data release. Consensus forecasts they will again "punt” the decision keeping all policies unchanged and maintaining the narrative that additional data is needed to confirm inflation is moderating. This assumes no unexpected drop in the CPI.

Attention will then focus on Fed Chair Jerome Powell's remarks, though consensus again indicates he will stay on message from previous meetings. Even if expectations of a September rate cut are realised, one more meeting and the Jackson Hole Symposium remain to "telegraph" the change to markets. In other words, the Fed can continue advocating for more information while cutting rates in September.

How to Gauge Risk

USDJPY may be quite vulnerable to deviations from forecasts, as higher inflation and a more aggressive Fed could outweigh attempts to keep FX rates in line with norms. This comes only two days before the BOJ meeting, where interest rates are anticipated to remain steady.

It has been steadily consolidating within a narrowing range, poised for a forceful movement, either lower or higher, contingent upon forming a triangle pattern prior to the events. Should bullish sentiment prevail and lift the pair past 157.75, further upside towards 160 and beyond could ensue, whereas a break below 154.55 may herald a decline to 151.80.

Source: SpreadEx / USDJPY

Key Takeaways

Markets are expected to be volatile tomorrow due to the release of the CPI inflation data, which could show whether inflation is declining as expected. This will be followed shortly by the FOMC meeting, where the Fed will decide on interest rates. The market expects an interest rate cut in September, but the strong jobs report from last week cast some doubt on that. The upcoming CPI data could confirm that inflation is moderating. However, just before the FOMC, markets may need more time to adjust their expectations. Attention will be paid to the Fed Chair's remarks to gain further clues about the Fed's thinking.