This week’s stock market is particularly focused on the Consumer Price Index (CPI) reading this Wednesday because it is a critical indicator of inflation, which directly influences Federal Reserve policy and, by extension, financial markets. This is why it matters and will shape short-term sentiment.
Fed Policy Implications
- The CPI measures changes in the price of goods and services and serves as a gauge of inflation. If inflation remains elevated, it may prompt the Federal Reserve to maintain or even raise interest rates, which could pressure borrowing costs and slow economic growth.
- Conversely, a softer CPI reading could signal that inflation is moderating, potentially leading to a pause or easing in rate hikes, which markets typically interpret positively.
Market Expectations
- Investors are trying to anticipate the Fed’s next move. Higher-than-expected inflation could renew fears of prolonged tight monetary policy, weighing on equities.
- A lower CPI reading might boost investor confidence, as it would suggest the Fed’s rate hikes are working and could lead to a less restrictive stance.
Corporate Earnings and Valuations
- Inflation impacts consumer spending and input costs, both of which affect corporate profits. Elevated inflation erodes margins and disposable incomes, which could dampen growth expectations and stock valuations.
Bond Yields and Competition with Equities
- Inflation data also impacts bond yields. A high CPI could push yields higher as investors demand greater compensation for inflation risk, making bonds more attractive relative to stocks. This could lead to sector rotations or broader market selling.
Market Sentiment and Volatility
- The CPI release is a key driver of market sentiment. Traders often position ahead of the report, leading to heightened volatility before and after its release. Any surprises—upward or downward—could spark significant moves across asset classes.
Conclusion
The CPI reading on Wednesday is pivotal as it provides fresh insight into inflation trends and the potential trajectory of Federal Reserve policy. With markets already grappling with uncertainties like rising bond yields and the uncertainty of the new administration’s policies, this data point could set the tone for market performance in the weeks ahead.
Bond Yields Surge as Markets Face Volatility
The stock market wasn’t expected to start 2025 with a stumble, but that’s exactly what happened. Conventional wisdom had predicted that the momentum from the post-election rally in late 2024 would carry into the New Year. Instead, equities have taken a sharp turn downward since early December, driven in part by a surge in long-term bond yields.
The yield on the 10-year Treasury climbed to 4.769% by the week’s end, its highest level since May, up dramatically from September’s low of 3.6%. This increase directly impacts mortgage rates—now hovering between 6.95% and 7.3%—cooling demand for housing and potentially slowing economic growth.
Why Are Bond Yields Rising?
The rapid increase in yields is largely attributed to the government’s unprecedented supply of debt issued last week. To fund its growing deficit and major fiscal programs, the Treasury auctioned a significant volume of long-term bonds, creating a supply-demand imbalance. Investors demanded higher yields to absorb this supply, reflecting concerns about fiscal sustainability and future inflation.
Additionally, inflation remains stubbornly above the Federal Reserve’s 2% target, and robust job growth from Friday’s employment report reinforced the belief that interest rates will remain elevated for an extended period. The “last mile” to achieving the Fed’s inflation goal appears to be longer than anticipated.
Bull Markets Are Built on Earnings
Despite these headwinds, it’s important to remember that bull markets are driven by corporate earnings—and the outlook for 2025 earnings remains optimistic. Analysts are forecasting a solid recovery in key sectors such as technology, financials, and industrials. Companies like Delta Air Lines (+9% on strong earnings) and United Airlines (+3.3%) are setting a positive tone for earnings season, with many expecting robust growth to offset broader market concerns.
Market Performance Last Week
All major indexes ended the week sharply lower. The S&P 500 dropped 1.9%, the Dow Jones Industrial Average shed 2.5%, and the NASDAQ Composite fell 2.3%. The S&P 500 is now 4.5% below its Dec. 6 all-time high of 6,099.97, reflecting growing investor unease.
However, not all stocks were caught in the downdraft. Nvidia rose 1.2%, benefiting from optimism about AI demand, while Delta and other airline stocks surged on strong guidance. Conversely, sectors like technology, which had led gains in 2024, experienced notable pullbacks as higher yields weighed on valuations.
The fires and inflation
Insurers like Allstate (-5.6%) and Mercury General (-20%) are reeling from projected losses, with some estimates placing damages between $52 billion and $57 billion in specific regions. There is a strong possibility the fires will lead to inflationary readings in the months ahead. I expect a noticeable uptick in the following…The recent wildfires in Los Angeles are anticipated to influence the used car market, rental prices, construction and building materials, and homeowner insurance rates.
- Increased Demand for Replacement Vehicles: The fires have led to the destruction of numerous vehicles, prompting affected individuals to seek replacements. This surge in demand can elevate prices in the used car market.
- Rental Prices: The destruction of numerous homes has led to a significant reduction in housing supply, causing a surge in demand for available properties. This imbalance has resulted in landlords increasing rental rates, with some instances of price gouging reported. Such practices not only strain displaced residents but also contribute to overall inflation in the housing market.
- Construction and Building Materials: The need to rebuild damaged infrastructure and homes has escalated the demand for construction services and materials. This heightened demand can lead to increased prices for building materials such as lumber, steel, and concrete, as well as higher labor costs, thereby affecting the overall cost of construction projects.
- Insurance: The substantial claims resulting from wildfire damages are likely to prompt insurance companies to reassess risk models and increase premiums. Even if your insurance company was not affected by the fire, you have to remember insurance companies spread the risk through all policyholders. Often when one insurance raises rates, so do others, as they see it as an opportunity to profit. (Ohh, the capitalist system we live in.)
In summary, the Los Angeles wildfires are expected to drive inflationary pressures across multiple sectors, including the used car market, rental prices, building materials, and insurance premiums. These impacts are likely to be reflected in future economic reports throughout 2025. While this may be viewed as a temporary or “one-off” event, markets could still interpret it as inflationary. This scenario places the Federal Reserve in a difficult position: either it holds rates steady longer than markets anticipate, risking dissatisfaction, or lowers rates, which could be perceived as fueling inflation. Either outcome is likely to contribute to heightened market volatility in 2025 (This is important to remember! Remember to raise cash when the opportunity presents itself.)
Looking Ahead
This week’s focus will be on key inflation reports and a wave of earnings announcements, particularly from financial institutions. Investors will watch closely for signs that inflation is cooling or that corporate guidance can provide a buffer against rising rates.
While the recent market pullback may seem alarming, the historical context is reassuring. Corrections of 5% or more occur three times annually on average, with 10% of corrections happening once per year. Longer-term, sustained bull markets hinge on earnings—and if corporate America delivers as expected, 2025 could still prove to be a profitable year for investors.
For now, the debate between bulls and skeptics continues. It is going to be a challenging year. With valuations stretched and uncertainty abating on the new administration’s policies and a rudderless Federal Reserve, I expect further confusion, which leads to volatility. However, with robust earnings on the horizon, there’s reason to remain cautiously optimistic. (For the traders and not the long-term holders, it’s good to remember to raise cash if the opportunity presents itself.)