Insights 
VT 
The US CPI report is the main focus for markets this week. Recent weak economic data has led traders to consider a possible rate cut in September, as Federal Reserve policymakers take a more cautious approach. Concerns may arise if inflation exceeds expectations.
The risk of stagflation is growing, worrying market participants.
Inflation Expectations for July
Expectations suggest a 0.2% monthly increase in headline inflation for July, down from 0.3% in June. Nonetheless, the annual rate is expected to rise to 2.8%, up from 2.7% previously.
Core inflation is anticipated to increase by 0.3% monthly, compared to 0.2% in June, with a year-on-year estimate expected to rise to 3.0% from 2.9%.
Core inflation figures are more important, but the report’s details matter greatly. Monitoring any extra passthrough of tariffs from businesses to consumers is essential, as increased occurrences could challenge the Federal Reserve.
Policymakers might draw on past strategies, potentially labeling inflation as “transitory” to support rate cuts later in the year, suggesting that tariff-induced inflation could temporarily push prices up.
Nonetheless, persistent inflation will complicate the Federal Reserve’s decisions and keep markets on their toes as September nears.
With the important US Consumer Price Index (CPI) report due this week, we are positioned for a significant market reaction. Market pricing on CME Fed Funds futures now implies a 65% chance of a rate cut in September. This is driven by recent weak data, like the Q2 GDP growth coming in at just 0.9% and the unemployment rate ticking up to 4.2%.
Hot Inflation Risks
The key risk is that a hot inflation number could shatter these rate cut hopes, introducing the threat of stagflation. This uncertainty has already pushed the CBOE Volatility Index (VIX), the market’s fear gauge, up from its lows near 13 earlier this year to over 18. We are watching for any signs of a larger spike.
Expectations are for the annual headline inflation rate to rise to 2.8%, with core inflation climbing to 3.0%. A number above these forecasts would challenge the Federal Reserve’s recent dovish pivot. It would suggest that price pressures are becoming persistent again, even as economic growth slows.
Given this binary outlook, we see value in strategies that benefit from a large price move in either direction. For example, options strangles on the S&P 500 or Nasdaq-100 indices could be an effective way to trade the volatility around the CPI release. These positions profit whether the market rallies on a soft report or sells off on a hot one.
We are also closely watching the interest rate derivatives market, particularly options on Treasury note futures. A CPI report that is much hotter than expected could cause yields to spike, crushing the narrative of a forthcoming rate cut. Traders are positioning for this potential shock to bond prices.
The Fed’s potential framing of inflation as “transitory” due to tariffs brings back uncomfortable memories. We remember how the Fed used similar language back in 2021, only to see inflation surge to 40-year highs, which forced the aggressive rate hikes of 2022 and 2023. The market’s patience for this narrative is likely thin.
Any evidence in the CPI report that businesses are passing on higher tariff costs to consumers will be a major red flag. This kind of inflation is difficult for the Fed to control with monetary policy. It would put policymakers in a very difficult position ahead of their September meeting.
