So what is going on here? The most logical explanation goes something like this: from a macro perspective, the market fears US economy overheating; an acceleration in inflation, and a Fed ‘behind the curve”. With this big picture view, the positioning going into CPI data is defensive whereby short-term spec USD shorts are trimmed.
If the CPI data comes in below expectations, the USD sells off. If the USD comes at expectations the USD also sells off not least because the market has priced in core CPI at 0.2% for every month since October 2015, and a 0.2% number in any one month will not add to inflation fears. Even when the core CPI data is above expectations, there is a chance that there is some risk relief trade occurring, as the market takes a view that its very worst fears were not founded, and the number is ‘not game changing’ because i) core CPI tends to come in no more than 0.1% above expectation in any one month, and ii) besides, after the CPI release there is a long one month window before the next big CPI number could add to fears of overheating.
For the coming CPI release, the positive risk reaction is also likely to be true for the bond market. The CFTC data suggests the market is already very short the belly of the curve and 10y sectors. Similarly, price action has shown bond bears struggling to gain traction for an assault on the 10y resistance area at 3% – 3.03%. This is a bond market that appears to need stronger inflation data simply to validate the existing positioning. Now a 0.3% core CPI for February would be significant as the third consecutive month of upside surprises, and for that reason we would expect an orthodox response to stronger data. However, as long as bond yields do not back up sharply and 10s do not change to a 3 handle, the impact on equities and the USD should be restrained.
In sum, on stronger than expected CPI, some reversal of Friday’s view of the benign wage data should be evident, with EM and the commodity complex selling off versus the USD, while the EUR and CHF barely budge, and the JPY strengthens slightly.
On as expected data, risk should rally at least modestly, and the USD generally track weaker. This move would be amplified if core CPI comes in below 0.15%. In other words, the trading reaction is seen as asymmetrically biased at least modestly USD negative.