Many market participants have Tuesday's US CPI report circled as a possible turning point in markets.

The PCE report is the Fed's preferred inflation metric but with the earlier release of CPI, it's stolen the limelight and has the larger market impact. That's particularly true at the moment with the Fed fighting struggling in the battle against high prices.

Comments late last week from top Federal Reserve officials suggest that even a soft CPI won't dissuade a 75 basis points cut but the report will have ramifications for rates further down the line and could impact Fed communication at next week's meeting.

At the moment, the market is pricing in a 93% of a 75 bps hike and I don't see CPI changing that. Where it could leave a bigger mark is the terminal expected level of rates. That currently sits at 4.01% for March 2023.

Some goods news came today with a New York Fed survey showing one-year inflation expectations at a 10-month low and three-year inflation expectations at the lowest in nearly two years.

But Fed officials will want to see actual progress before relenting from their hawkish stance. The expectations for the CPI report are:

  • +8.1% y/y vs +8.5% prior
  • -0.1% m/m vs 0.0% prior
  • Core +6.1% y/y vs +5.9% prior
  • Core +0.3% vs +0.3% prior

From those numbers, the tension in the report is obvious. Headline inflation has flattened while core continues to accelerate at an alarming pace.

At some point, the softening headline will feed back into the core -- unravelling what happened previously -- but for the Federal Reserve they need to see the clear evidence before any kind of pivot. This will certainly be another step in the right direction but the Fed is highly protective of its inflation-fighting credibility and will stay hawkish for now.

At the same time, the market is forward looking and may not wait for the Fed to pivot to price in a turn. Energy prices continue to fall and pandemic-affected supply chains are healing. At this time next year, inflation could be back to target but it will all depend on how core develops.

I asked traders for their views on trading Tuesday's report and what they'll be focusing on and I think the majority is right.

CPI poll

Simply, if both are strong we'll see the US dollar strengthen; if both are weak, we'll see the dollar weaken.

Where it gets interesting is if they're opposing.

If headline is cool but core is hot, we will see some dollar strength. If headline is hot but core is cool, we'll see dollar weakness. That all depends on how much each of them miss but in general, I will defer to core because that's what the Fed is watching closest.

The cleanest trade is likely to be in GBP/USD as anything that softens the dollar will also boost stocks and there's a decent correlation between cable and stocks. Similarly, a high reading will boost the dollar and hurt stocks, weighing on GBP.

Overall, I get the sense that many traders are looking to trade a Fed pivot and signs of softness in CPI would play into that. The reaction would be strength in equities, adding to recent moment. In general, that will mean dollar softness.

The data is due out at 8:30 am ET (1230 GMT).