Dollars and Data: Unpacking the US Inflation Report Rollercoaster

So, the US inflation report for December didn't exactly set the market on fire. It caused a brief dollar rally, with the US dollar index going up from 102.20 to 102.70, but it lost all its gains later on. Even the two-year rate took a dip, from 4.34% before the report to 4.26% on Friday:In my last piece, I talked about how the market could react asymmetrically to the report. If inflation slightly beat expectations, the markets would shrug it off in anticipation of the Fed's potential rate cut in March which is widely discussed at the moment. Conversely, if inflation fell below forecasts, the reaction could be substantial. It seems that's what happened – the market's response suggests investors interpreted the report as if it didn't change the outlook for the March Fed meeting or even reduced the chances of a rate cut. However, price data indicates that the opposite had to happen: both overall and core inflation in December exceeded forecasts (3.4% vs. the expected 3.2% and 3.9% vs. 3.8%, respectively).Monthly core inflation was 0.3%, in line with expectations. Report details also showed that Fed-sensitive inflation components, like service prices and housing-related services, had mixed dynamics. The growth in services slowed compared to the previous month (0.4% in December vs. 0.5% in November), while housing-related services accelerated (0.5% in December vs. 0.4% in November). It's worth noting that the "Shelter" component, accounting for over 30% of the core CPI, could explain why the indicator grew stronger than expected:The asymmetrical reaction to the report might be due to preliminary indicators for late November-December (wage growth, consumer sentiment index, surge in consumer credit volumes) already hinting that inflation might surpass consensus forecasts. So, the market priced in the possibility of an upside surprise but probably wasn't as ready for a downside surprise. However, the fact that the ‘Shelter’ component is picking up speed again creates the risk that the market underestimates the March outcome, where the Fed takes another pause. For instance, yesterday, Fed official Loretta Mester, in response to the CPI report, stated that cutting rates in March is likely premature. In my view, there's an opportunity to bet on a market reassessment in favor of another Fed pause in March, meaning the dollar might strengthen in the next couple of months. Currently, the market assesses the chances of a March rate cut at 70%; yesterday it was 70.2%. This indicates that the market pretty much ignored the CPI report. However, keep an eye on potential reassessments of rate-cut expectations by other central banks. For example, the market expects the ECB to cut rates by a total of 140 basis points, so there is decent room for hawkish repricing too. Today, the US producer price index will also be released, and if there's a surprise, it could trigger a more significant market reaction, especially if the surprise is on the upside. The consensus forecast is 0.1% for the overall index and 0.2% for the core index on a monthly basis.