Investors may be in for a significant surprise if Wednesday's Consumer Price Index (CPI) report comes in higher than anticipated, warns Gavekal Research.
The markets are currently banking on aggressive interest rate cuts by the Federal Reserve, but a rise in inflation could quickly unravel these expectations, leading to what Gavekal terms a "nasty shock."
They note that the futures market is currently pricing in a 100% certainty of a rate cut on September 18, with a 50% chance of a more substantial 50 basis point cut.
Furthermore, there is an expectation of a full 100 basis point cut by the end of 2024.
However, Gavekal cautions that an uptick in inflation could trigger a "violent position adjustment," forcing investors to rethink the Fed's trajectory.
According to Gavekal, the debate within their team reflects the uncertainty in the broader market. Some analysts believe structural factors will push inflation above the Fed's 2% target, while others argue that factors like a contraction in money supply and easing supply bottlenecks will curb inflation.
"Yes, July's employment report showed the labor market continues to cool. This implies wage growth will continue to moderate, reinforcing the disinflation narrative. At the margin, it adds to the case for rate cuts. But an uptick in inflation would undermine this case in the short term," said Gavekal.
The Fed's willingness to cut rates hinges on inflation cooperating. If inflation surprises on the upside, the Fed might delay cuts, causing a rebound in the US dollar, higher bond yields, and pressure on US equities, especially growth stocks.
Gavekal suggests that in the event of such an inflation scare, the safest assets might be US dollar cash, T-bills, and inflation-protected treasuries. As Gavekal notes, with so much riding on the upcoming CPI release, it may be prudent for investors to brace for potential volatility on Wednesday.