Over the past two years since the Federal Reserve began actively combating inflation, stock traders have been watching the screen whenever the Consumer Price Index (CPI) is announced. But when the latest CPI data is released this Wednesday, the situation is expected to be different.

Why? Because as inflation falls towards the Federal Reserve's target, the Fed is prepared to cut interest rates, and this data is not as important for the stock market. Instead, everything is related to the weakness in the job market and whether the Fed can avoid a hard landing.

"The key question facing stock market investors is whether the Fed waited too long to cut interest rates, because the current risk of a recession is higher than it was two months ago," said Eric Diton, President and CEO of Wealth Alliance. "Suddenly, inflation is no longer a big issue."

The S&P 500 index just had its worst week since Silicon Valley Bank's collapse in March 2023, with large tech stocks falling, and Nvidia dropping 14%. Volatility has also rebounded, with the CBOE Volatility Index rising from 15 on August 30 to nearly 24 on September 6. $CBOE Volatility S&P 500 Index (.VIX.US)$ Options traders are betting that there will be even greater volatility, but lower than the market's expectations of the CPI. As of last Friday morning, they expect the S&P 500 index to fluctuate up and down by 0.85% this Wednesday.

Option traders are betting that volatility will increase, but it is lower than the market's expectations for CPI's day. As of last Friday morning, they expected the S&P 500 index to fluctuate by 0.85% on Wednesday this week.

According to data compiled by Piper Sandler, if this target is achieved, it will be the smallest daily fluctuation in CPI since the beginning of the year. On the other hand, traders expected the implied volatility of the S&P 500 index to be 1.1% before the weak non-farm payroll report was released last Friday. According to data compiled by Susquehanna International Group, this is one of the highest absolute values ​​so far this year, 83% higher than the average implied daily volatility in 2024. The index fell 1.7% that day, even exceeding expectations.

"The stock market has had a strong rally this year," Diton said. "So why not take some profits?"

Basically, the market's perception has changed now, and rate cuts are considered inevitable, but the strength of the economy seems less robust. On August 23rd, Federal Reserve Chairman Powell declared almost a victory against inflation in a speech at the Fed's symposium in Jackson Hole, Wyoming. Since then, more policymakers such as New York Fed President Williams, Chicago Fed President Guolsby, and Fed Governor Warl have all expressed the need to lower interest rates, but the extent of the rate cut is still debatable.

Now, the Federal Reserve is shifting to the other side of its dual mandate, which is maintaining maximum employment. According to data from the US Bureau of Labor Statistics, the jobs report on Friday showed that non-farm payrolls increased by 0.142 million last month, bringing the three-month average to the lowest level since mid-2020.

Looking ahead to the Federal Reserve's interest rate decision on September 18th, the swap contract fully reflects the expectation of at least a 25 basis point rate cut. Meanwhile, data compiled by UBS Group shows that implied volatility is accelerating before significant macroeconomic events related to employment occur, and stock market volatility indicators such as skew are still at high levels as traders hedge against further downside risk in the stock market. Rocky Fishman, founder of derivative analysis company Asym 500, said: 'The skew suggests that there is additional value in providing downside protection. If the results are indeed disappointing from a macro perspective, the potential decline in the stock market may be greater than previously imagined.'

Currently, investors have sufficient reason to be more cautious about employment data than inflation data. The S&P 500 index recorded its worst daily employment data since 2022, falling 1.8% on August 2nd (Friday), and falling another 3% on August 5th due to weak employment reports. Two weeks later, the inflation data was basically in line with expectations, and the S&P 500 index only rose 0.4%, the smallest daily increase in CPI since January.

UBS Group data shows that traders expect the volatility of the S&P 500 index to rise, as the demand for out-of-the-money put options is higher than out-of-the-money call options. UBS Group stated that commodity trading advisors (CTAs) grasp the trend of asset prices in the futures market by taking long and short positions, and they believe that there is little room to add positions at the moment.

The volatility index (VIX) that measures the implied volatility of over-the-counter options for the benchmark US stock index futures is currently at a low level just above 20, which in itself does not necessarily indicate danger. However, this index is 52% higher than this year's average level, and the volatility curve suggests that risks will increase in the coming months.

Fed officials have entered a pre-meeting silent period and will not make any comments before September 18th. However, the latest Beige Book shows that compared with inflation, business contacts are more concerned about the slowdown in economic growth. The Beige Book collects information from business contacts in 12 regions. However, the report does not mention "economic recession", but only mentions "inflation" 10 times, which according to DataTrek Research is the lowest level since 2024.

While there is a widespread expectation that the USA economy will remain strong, the GDPNow model from the Atlanta Fed shows some slowing, with the actual GDP growth rate for the third quarter expected to be 2.1%, lower than the roughly 3% a few weeks ago. This is just another signal that indicates the need for the Federal Reserve to cut interest rates before it's too late to prevent an economic recession. If they do not do so, those investors who have driven up the stock market due to the expectation of policymakers soon lowering borrowing costs might have to consider the old saying, "Beware of what you wish for."

Diton stated that if the stock market intensifies its concerns over the Federal Reserve's failure to adequately address the economic slowdown, the situation becomes even more critical. An economic slowdown will ultimately impact corporate profits. "Everyone is now looking at every single data point about the economy and employment," he said. "If the data continues to weaken, there will be more selling."

Editor/Somer