The Big Picture

There was a significant rally in the stock market and the Treasury market following the release of the December Consumer Price Index (CPI). We're not sure which was more surprising: that the stock market rallied like it did or that the markets thought the CPI report was actually good.

We will concede that the CPI news was better than expected, but to call it truly good is a stretch to assign causality to a rally that was more about a change in positioning than a change in position.

Off Target

The Federal Reserve's inflation target is 2.0%. That target is tied to the PCE Price Index, which has different component weightings than the CPI does and captures the substitution effect that the CPI, which is based on a fixed basket of goods and services, does not.

Those are key reasons why PCE inflation, as well as core-PCE inflation, runs below CPI and core-CPI inflation. In any case, inflation is still running comfortably above the Fed's 2.0% target, particularly core inflation which the Fed views as the better measure of long-run inflation trends since it excludes the volatile categories of food and energy.

Core-PCE inflation was up 2.8% year-over-year in November; meanwhile, core-CPI, which market participants were reportedly thrilled to see, was up 3.2% year-over-year on an unadjusted basis in December.

The excitement over that core-CPI number is that it was down from 3.3% in November -- no doubt moving in the preferred direction but also leaving no doubt that it isn't progressing to 2.0% in a rapid way. It should be noted that the "3.2%" was a more generous headline presentation versus the unrounded 3.24% number.

It is also worth pointing out that core-CPI has been between 3.2% and 3.3% (rounded) for the last seven months, so it doesn't compute that a market worried about sticky inflation over that same period was suddenly overjoyed by an inflation reading it has bemoaned for most of that time.

Some other tells that the market didn't see any real inflation relief in that CPI report included the following:

• The five-year breakeven inflation rate (a measure of what market participants expect inflation to be in the next five years, on average) barely budged the day of the report (Jan. 15). It settled at 2.52%, down three basis points from where it settled on the day of the PPI report (Jan. 14) but up one basis point from where it settled on Jan. 10 before all the "good inflation news" hit. It is essentially unchanged from where it was in October 2023.

• The fed funds futures market didn't change its rate cut perspective. There is a 69.9% probability of the next rate cut happening at the June FOMC meeting (versus 72.8% a week ago) and a 54.2% probability of a second rate cut at the December FOMC meeting (versus 54.2% a week ago), according to the CME FedWatch Tool.
• Gold futures, which garner interest as an inflation hedge, increased 1.3% after the CPI report and were up 1.2% for the week as of this writing.

Countervailing Forces

The December CPI report was not devoid of encouraging information. Arguably, the most encouraging development was the disinflation in the lagging shelter index, which is the most heavily weighted component in the CPI report. It was up 4.6% year-over-year on an unadjusted basis, which is the lowest rate of inflation since January 2022.

This component is definitely headed in the right direction but countervailing inflation forces are in play, namely rising oil and natural gas prices, the elevated prices-paid indexes in the ISM Manufacturing and Services PMI reports, President-elect Trump's push to use tariffs to attack U.S. trade deficits with other countries, and policies aimed at deporting illegal immigrants.

The strong dollar will help temper some inflation pressures but, again, breakeven inflation rates haven't adjusted yet in a manner that would suggest the market has confidence in inflation getting back to the Fed's 2.0% target and staying there.

What It All Means

So, why did the stock market and Treasury market rally like they did after the December Consumer Price Index? Call it a relief trade for markets that had been fretting sticky inflation, particularly the Treasury market, which had already seen the yield on the 10-yr note increase 100 basis points since the Fed cut rates by 50 basis points last September when core-CPI and core-PCE were at 3.3% and 2.7%, respectively.

It was the opposite of good news being priced in. In effect, bad inflation news had been priced in, so it became a rallying point when the month-over-month change for CPI (+0.4%) was in-line and slightly better than expected for core-CPI (+0.2%).

Some pundits were quick to label the report better than expected. The better description in our humble opinion was "better than feared," which was good enough to ignite a trading rally and short-covering activity that produced outsized gains for the Treasury market and the stock market.

The 10-yr note yield, which saw 4.80% on January 14, settled at 4.65% on January 15. The S&P 500, Nasdaq Composite, and Russell 2000 logged their best gains since November 6 (day after the election).

The summation is that both markets had gotten into a short-term oversold condition and were primed to bounce on any whiff of news that had a glint of positivity associated with it. The December CPI report fit that bill and, to be fair, had some marquis company with the better-than-expected earnings results from some of the nation's largest financial institutions and the news of a ceasefire deal between Israel and Hamas.

The pacing in the Treasury market, though, made it clear that the CPI report was the primary catalyst for the relief rally given that stocks had been languishing in recent weeks as rates continued to rise.

They were going up at a time the market knew core-CPI was stuck between 3.2% and 3.3%. That didn't change in December. The CPI report was better than feared, but with a 3-handle still on core-CPI, let's not stretch the truth and call it good just yet.

--Patrick J. O'Hare, Briefing.com

(Editor's Note: The Next installment of The Big Picture will be published the week of January 27)