What Do the Latest U.S. Inflation Data Tell Us?

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The U.S. inflation report for December, released on January 15th, presented mixed signals but has been positively received by the markets.

Consumer prices rose by 2.9% year-over-year, aligning with economists' expectations and accelerating from the 2.7% recorded in the previous month. However, monthly inflation surprised to the upside, increasing by 0.4% compared to November, exceeding the 0.3% forecast. 

On a brighter note, core inflation (excluding volatile energy and food prices) came in below expectations. It posted a 3.2% year-over-year increase, down from both the 3.3% anticipated by economists and the prior month’s reading. On a monthly basis, core inflation rose by 0.2%, which was in line with forecasts.

The main drivers of price increases were used vehicles and transportation services, trends already evident in the day before producer price index (PPI), which, despite coming in below expectations, had limited impact on market sentiment. 

While housing costs rose only moderately on a monthly basis (+0.3%, consistent with the prior month), no major category of goods or services saw a price decline compared to November. This contrasts with previous reports and underscores a strengthening U.S. economy.

Market Reaction

Despite some worrisome signals, the market response was decidedly upbeat:

  • 2-Year Treasury yields fell by 9 basis points to 4.3%.
  • The likelihood of at least two Federal Reserve rate cuts in 2025 increased from 35% to 47% following the report.
  • The S&P 500 gained 1.5%, driven by strong performance in financials (boosted by promising earnings in the sector) and technology stocks. 

A Closer Look at Market Dynamics

Part of this positive reaction appears to be driven by technical factors.

In recent days, many institutional investors positioned for negative inflation surprises by increasing short positions in equities and Treasuries, as evidenced by rising VIX and MOVE Index levels (indicating heightened hedging activity).

When the core inflation reading came in slightly better than expected, these positions were unwound, triggering a short-covering rally and a sharp drop in market volatility (VIX declined by 11%). 

Challenges Ahead

However, the broader picture remains complex.

  • Long-term inflation expectations are trending higher, creating headwinds for riskier assets. This is particularly evident in the negative correlation between the Nasdaq 100 and rising inflation expectations.
  • While corporate earnings may continue to support the market, the Federal Reserve, which closely monitors quarterly and semi-annual inflation trends, could adopt a more hawkish tone at its next meeting later this month.

In conclusion, while today's inflation report has offered markets some relief, the underlying dynamics suggest a cautious outlook as the Fed navigates a strengthening economy and persistent inflationary pressures.


 



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