Will tomorrow's US CPI exceed expectations? Wall Street is more concerned about employment!

Despite the market widely expecting the U.S. inflation data to be "hot" again when released on Thursday, Wall Street's trading focus has quietly shifted. Compared to the single inflation data, investors are now more concerned about the health of the job market.

According to the pricing in the options market, traders expect the S&P 500 index to record only about 0.7% moderate volatility after the CPI data is released. This expectation is not only lower than the average actual volatility of 0.9% on CPI release days over the past year but also lower than the market pricing for the next employment report. Stuart Kaiser, head of U.S. equity trading strategy at Citigroup, even believes that this 0.7% implied volatility seems high.

This calm expectation in the market is rooted in the judgment of the Federal Reserve's interest rate path. Wall Street generally believes that U.S. employment data has shown signs of weakness that could threaten economic growth, which will prompt the Federal Reserve to cut rates by 25 basis points at the meeting on September 17, with potential further actions in October and December. Currently, the market has fully priced in expectations of more than 100 basis points of rate cuts over the next year.

Nevertheless, inflation has not completely exited the stage. A significantly higher-than-expected inflation report, while unlikely to prevent the Federal Reserve from cutting rates this month, could shake the path of subsequent rate cuts. Andrew Tyler, head of global market intelligence at JP Morgan, wrote in a report to clients:

“We do not believe this report will pose a credible threat to the Federal Reserve's pause in rate cuts in September, but a significantly hawkish data point would indeed adjust the Federal Reserve's response function for the October and December meetings.”

Market Calm: Options Pricing Indicates Limited CPI Impact

In the face of the upcoming U.S. August CPI report, traders appear unusually calm.

Stuart Kaiser of Citigroup points out that the approximately 0.7% expected volatility for the S&P 500 index reflected in options market pricing clearly indicates that the market believes the likelihood of inflation data causing severe turbulence is low. The core logic of this pricing strategy is that in the current macro narrative, the importance of labor market data has overshadowed inflation.

This view is echoed in the strategies of major investment banks. Economists at Barclays have adjusted their forecasts and now expect the Federal Reserve to cut rates three times by 25 basis points each this year, with two more cuts in 2026. This reflects that the market has shifted its policy focus from combating inflation to addressing potential economic slowdown.

As previously mentioned in a report, the CPI swap rates currently expect the year-on-year increase in August CPI to be 2.91% and the month-on-month increase to be 0.38%. Both figures are above economists' consensus. The median forecasts from economists surveyed by Bloomberg for the year-on-year and month-on-month increases in CPI are 2.9% and 0.3%, respectively.

At the same time, Morgan Stanley's Diego Anzoategui predicts that the year-on-year increase in August CPI will reach 2.92%, also slightly higher than the pricing in the swap market. The bank's economists believe that although inflation in services such as airline tickets and dental services is slowing, the impact of tariffs will be more significant than in previous months

JP Morgan's Analysis: Market Reactions Under Different Inflation Data

To respond to the potential outcomes of the CPI data, JP Morgan's trading department has provided clients with a clear scenario analysis. According to Andrew Tyler's report, economists generally predict that the core CPI will rise by 0.3% month-on-month and 3.1% year-on-year in August, a level still far above the Federal Reserve's target of 2%.

In the bank's view, the most likely scenario is that the core CPI month-on-month growth will be between 0.3% and 0.35%, which will lead to the S&P 500 index fluctuating within a range of a 0.25% decline to a 0.5% increase. If the data is better than expected, with month-on-month growth between 0.25% and 0.3%, the index is expected to rise by 1% to 1.5%; if the data unexpectedly drops below 0.25%, it could trigger an increase of 1.25% to 1.75%.

Conversely, if the core CPI month-on-month growth exceeds 0.4%, it could lead to a decline in the S&P 500 index of up to 2%. However, Tyler believes that the probability of such an extreme scenario is only 5%.

The Final Deciding Factor: The Labor Market

Another support for current market sentiment comes from the resilience of the macroeconomy. The Atlanta Fed's GDPNow model predicts that the annualized growth rate of the U.S. real GDP in the third quarter will reach 3%, slightly lower than the 3.3% in the second quarter, but still strong. Meanwhile, the Cboe Volatility Index (VIX), which measures market panic, is far below the critical level of 20, while Citigroup's U.S. Economic Surprise Index hovers near its highest point since January.

However, strong economic data is a "double-edged sword" in the current environment. Better-than-expected economic performance usually benefits the stock market, but it may also complicate the Federal Reserve's goal of controlling inflation, forcing it to maintain high interest rates for a longer period.

Ultimately, the direction of the market will be determined by the labor market. As Citigroup's Kaiser stated:

"It all depends on the labor market. If the Federal Reserve cuts rates in October, it may mean that labor data continues to be under pressure and that inflation has not shown unexpected upward movement."