Today's Consumer Price Index release was highly anticipated, and it didn't disappoint. At first glance it might seem innocuous: the headline was at +2.1% year over year, 1.8% when excluding food and energy. Both measures were the same as last month's release and just slightly higher than Bloomberg's economist survey. But with markets on edge about interest rates, it was enough to set stock futures plummeting and Treasury yields jumping.
Here are a few thoughts on trading here.
Is the Upward Momentum in CPI Real?
I'd bet on it being more real than not. It makes sense that with an economy performing as it is that inflation pressure would be growing. That being said, we should put it into context. Core CPI was running well above 2% in the middle of last year only to fall off. At 1.8% year over year, we aren't even above average for the last five years (the average being 1.9%). So, while I'm not surprised CPI is rising a bit, I still think of it as in the same general range that it has been over the last few years.
How Will the Fed React?
The Fed had been expecting inflation to recover and inch toward 2% (although they typically focus on the PCE Price Index, not the CPI, but regardless) so this should really just solidify the Fed's plan. Based on the dot plot, that means three hikes in calendar 2018.
The market had already fully priced in a March hike prior to this release, about a 65% chance of another hike in June, and then about a 50% chance of a third hike by December. I still think those odds are too low. The economy has too much momentum now to imagine that it falls way off by the summer, so those first two hikes are a near lock. The third should be more like 80% with a fourth hike somewhere in the 30-40% area.
So What Would You Trade?
I still love curve flatteners. That's by far the easiest way to play the Fed continuing to hike. I've detailed the trade I like here. I still like being net long, which I know is more contrarian. But I've got much more conviction in the flattener trade.
The Fed will react to increasing inflation by tightening policy. There are very low odds that the Fed let's inflation gets much above 2% on a sustained basis, at least as measured by Core PCE. A major reason why I believe what I said above about inflation being in the same range going forward is that the Fed just won't let it do anything else.
If inflation pressure has indeed got serious upward momentum, then the Fed will tighten policy, the 2-5 year part of the Treasury curve will rise in yield more than the longer-end will. If inflation pressures remain moderate because structural issues overwhelm strength in the economy, then longer-term interest rates will fall.
A trade I really don't like is getting long TIPS here. That market has priced in all the inflation that's coming already. Both the 5-year and 10-year TIP are pricing in inflation at or above 2%. That's a bad bet.
Last Thought on Stocks and Interest Rates
As I'm writing, stocks are coming back from the morning lows and given recent volatility I'm not going to guess where they end up. However, I will reiterate something I've been saying to clients and readers. The recent trend of higher rates and lower stock prices cannot persist. Interest rates will only keep rising if the economy stays strong. If the economy stays strong, earnings will also be strong, which in turn should support stock prices. If earnings are weak it will be because the economy has hit a soft patch. If that happens, interest rates won't keep rising.
I don't know exactly how long the positive correlation will last, but I suspect it will be about as long as it takes for the short-volatility trade to flush out. Perhaps if stocks can sustain a comeback today that will be a sign that the correlation has normalized.
This column originally appeared Feb. 14 on Real Money Pro, our premium site for active traders and Wall Street professionals. Click here to get great columns like this even earlier.