Trading the inflation card

Get used to hearing about inflation and rising interest rates.

You wouldn’t have known it if you fired up your trading screen after the market opened in the States, but yesterday’s higher-than-expected Consumer Price Index (CPI) number threw the (pre-) market for a loop when it was released at 8:30 a.m. ET, as evidenced by a five-minute chart of the March E-mini S&P 500 futures (ESH8):

March E-mini S&P 500 futures (ESH8), 2/14/18

Source: OptionsHouse

That’s what the pros refer to as a “1.8% Drop in Five Minutes.” Actually, they probably call it something else that can’t be printed here.

The CPI, which measures the prices of a basket of consumer goods and services, is a widely referenced inflation gauge. This latest report (reflecting January prices) likely represented to many traders and investors the arrival of potentially market-squelching inflation, which has been nervously anticipated for years but, until now, was almost entirely absent in most economic data.

Yet with a Fed still in rate-hike mode, Treasury yields climbing, and some wage pressures evident in the February 2 jobs report, the inflation story is likely to remain front-and-center for the time being—especially with nerves still frayed by the market’s recent correction. The relationship is typically not as cut-and-dried as some people occasionally make it, but all else being equal, (too much) inflation and rising rates traditionally don’t give equity investors warm and fuzzy feelings: Rising inflation could compel the Fed to increase interest rates more or faster than planned; higher rates increase corporate borrowing costs and negatively affect valuations.1

But before we get too worked up, there are two things to keep in mind right off the bat: 1) A single report does not a trend make; 2) The five-minute E-mini S&P chart shows that, less than one hour into the regular trading session, the market had pretty much rallied back to where it was before the CPI release. And with fewer than three hours left in the trading day, the S&P 500 (SPX) was up more than 1%.

But if we are entering a sustained rising-rate phase, some stocks might offer more long-side opportunities than others.

Financial stocks—a sector that’s also supposed to benefit from the tax overhaul—can have advantages in a rising-rate environment. Banks especially can be attractive since higher rates translate into a larger spread between the rates they earn lending money and the fixed rate they pay on deposits. That’s the basic concept, even if the reality isn’t that simple (or risk-free). Financial stocks, for example, are also typically front-line casualties when markets free-fall. But higher rates ultimately go directly to banks’ bottom lines.2

JPMorgan Chase (JPM) handled the recent correction better than a lot of stocks—it dropped only 11% (a little less than the SPX) and experienced its max loss entirely within the span of two days (February 2 and 5). As of yesterday, JPM had rallied more than 10% off its low, pushing back above $114.40, less than $3 away from its January 29 record high of $117.35.

JPMorgan Chase (JPM) and S&P 500 (SPX), 12/18/17 – 2/14/18

Source: OptionsHouse

The bank also received a recent analyst upgrade from Keefe, Bruyette & Woods (KBW), which hung an “Outperform” tag on JPM and a price target of $127.3

For now, we can all stay on inflation watch: Today features the Producer Price Index (PPI), which reflects the prices paid at the wholesale (producer) level. And real inflation wonks will look forward to the March 1 release of the Personal Consumption Expenditures (PCE) deflator—the inflation gauge favored by the Fed.


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1 Business Insider. The Fed's 4th rate hike could challenge a popular assumption investors make about stocks. 1/16/17.

2 US News & World Report. Investors Can Benefit from Rising Interest Rates. 1/22/18.

3 Dip Creates an Opportunity to Own Quality Bank JPMorgan (JPM), KBW Says in Upgrade. 2/13/18.