CPI Potential & Importance

2/14/18 (Long educational post today)

- Overall Market -

U.S stocks appear to have stabilized on lower volume trading for the time being. Dovish comments from new Fed Chairman Jerome Powell echoed Janet Yellen's position regarding liquidity when he said the Fed will "remain alert to any financial stability risks."

Many media outlets have been discussing the CIP (Consumer Price Index) and its significance. I feel this is an important topic to touch on and why traders should be alert.

There has been some money on the sidelines that has yet to buy this dip, why you may ask? Because the impact of this report may give clue as to a potential market shift and it's timing. To better understand the significance on why this monthly report is critical and more directly this reports results. 

- What is the CIP? -

So what is the Consumer Price Index? The text book answer... consumer price index (CPI) measures changes in the price level of market basket of consumer goods and services purchased by households. The CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically.

The simple answer; the CPI measures goods and services that you and I pay to live. It tracks how these costs rise over time and is released as a monthly report for public use. Remember the last time you were at the food store and said something akin to " X item is way more expensive than just last year". You may not actually say that but the point remains. 

The CPI is an attempt to measure over a broad picture (without getting into the macro of each market) how costs are slowly rising. 

This may be confusing on the surface as to why the report is important but it has a very deep tie to the heart of two things that impact equity markets. Those two topics are inflation and the central banks obligation to adjust interest rates. 

- Milk cost .0034 more this month, so what! -

While you may not care about incrementally increasing prices slowly over time, you should. Investors and economists are always looking to say ahead of the trend, to look for and identify potential shifts or changes in the market before they happen.  

This leads us into the next topic INFLATION. Few understand its far reaching impact and why it is so critical.

Inflation—the rise in the price of goods and services—reduces the purchasing power each unit of currency can buy. Rising inflation has an insidious effect: input prices are higher, consumers can purchase fewer goods, revenues and profits decline, and the economy slows for a time until a steady state is reached.

For quite some time inflation has been low and prices have remained stable. This keeps consumer spending high, propelling economic growth. As inflation remains low, interest rates also remain low (we will discuss why in our next section). When interest rates are low, bond yields are low, money is cheep to borrow. This skews risk reward in the favor of stocks. As you have seen a low rate environment can push stocks to incredible highs as we have recently experienced. 

Inflation occurs naturally over time as the cost of business rises it is passed on to the consumer. The fear becomes when jobs data (wage earning, wage increases, unemployment ect..) is no longer out pacing inflation. This is where central banks come in.

 

- A Necessary Evil -

Central banks receive a lot of heat and scrutiny, some of it is warranted, some not.  The duty of a central bank is massive in scope and a few miss steps can cause a country or global collapse. (yes central banks had a hand in the 2008 crisis.)

To oversimplify the central bank here is a very condensed list of duties.

  • implementing monetary policies.
  • setting the official interest rate – used to manage both inflation and the country's exchange rate – and ensuring that this rate takes effect via a variety of policy mechanisms.
  • controlling the nation's entire money supply.

In a nut shell, it is the central banks obligation to keep in check inflation and the value of the dollar. (some believe central banks should be removed and let the free market work itself out on its on.) 

As inflation starts to rise through measurable means as the CPI, the fed is forced to respond with monetary policy changes. The most common solution to inflation is to increase rates. Why? because in effect it can slow down the economy and keep inflation from getting ahead of itself. 

The broad idea behind this is simply put; debt becomes more expensive to leverage. Companies do not expand, rents go up and people are forced to buy homes to protect from rising rates, margins are reduced, over heads increased. The effect is the economy cools off for a bit and in theory individuals save more as rates make saving and bods more attractive. This  allows inflation to slow. 

wither you agree or disagree with this policy is irrelevant, it is a fact of our central bank and we must live with it. As investors or traders we must use every tool at our disposal. Keep in mind that CPI is a trade-able event for most currency traders. 

- Why this report is so critical -

The Fed has given statement in recent FOMC for the need to increase frequency of rate hikes. Now all they need is a reason to do so. Last weeks job report was less that stellar and called a contributing factor to the sell off. 

Should the CPI show inflation increasing above expected rate, there is cause for the fed to react and the market to respond in kind.  

The likely reaction in the case of inflation increase would be for fed to accelerate rate hikes or have larger basis point increases. As discussed risk reward on equity markets could slowly shift causing less buying overall. 

 

- Putting it all together -

While I have barely scratched the surface of the impacts of these topics and how they tie in to other aspects of the financial markets and economy, I do hope this helps provide clarity on why there is so much talk about this event today. 

Yes, it is true. You and I have little impact on the market when we buy or sell individually but fund managers and market analysts do. Sifts in the market come quietly in reports like this, when sentiment changes ever so slightly. Add up a few reports and fed statements, you can see how market cycles begin to form and price action occurs on a larger time-frame and scale. 

Typically by the time "dumb money" or retail traders realize what is happening the market is already made a major fundamental shift and are left holding the bag for smart money. 

None of this information will make you rich or provide you with a winning trade but I truly hope it opens your eyes to the importance in the little things that have huge impacts. the difference between .02 and .03 in this report may be all is needed to strike a uneasy tone in the market. 

I will look to capitalize on this in the short time with volatility. As you may well know by now, I am big on short term volatility trading during appropriate moments. Just be aware volatility trading has massive risks and should never expose large amounts of capital to. 

 

Keep risk at the forefront of any strategy you trade. Remain confident in your ability. If you have not traded in a correction before, take your foot off the gas and observe how the market trades.

Thank you again, and remain hungry and humble!

 

Disclaimer: We are not responsible for losses for any reason. We are just an investing club here, seek financial advise from a professional before acting on any of this information. This information is strictly my opinion and what I am seeing in the market. The information above is not a trade recommendation to buy or sell. I am not a licensed broker, dealer or finical adviser. Trading comes with considerable risk and may not be for everyone. Past performance is not indicative of future performance. Never trade with money you can not lose and paper trade to prove profitability before using real money.