Drop Because It’s Hot
The first Consumer Price Index (CPI) data of 2025 is in and it was hotter than expected across the board. Headline CPI (the index including all items) came in at 0.5% m/m and 3.0% y/y versus estimates of 0.3% and 2.9%, respectively. Core CPI (which excludes food and energy) wasn’t much better, coming in at 0.4% m/m and 3.3% y/y versus estimates of 0.3% and 3.1%, respectively.
No surprise that markets reacted poorly, with 10-year Treasury yields rising by 15 basis points (bps) and 2-year yields rising by 9 bps. Concurrently, the market’s expectation of Fed interest rate cuts fell to just one cut in all of 2025, and pushed the following cut out to the second half of 2026.
While stocks fell immediately following the report, they clawed much of those losses back by the end of the day. Treasury yields, however, held relatively steady at a much higher level than when the day began. The message this sends is that problematic inflation leaves very few places to hide, though investors are still inclined to shrug off fears in the near-term.
Built to Last?
As with most knee-jerk market reactions, this move was erased quite quickly as investors decided this report could be more of a blip than a sign of a lasting problem. Also worth noting: According to Morgan Stanley, CPI forecasts for January are the furthest off-the-mark than for any other month of the year. To play devil’s advocate on today’s market reaction, we think it’s important to point out the pattern that was evident pre-pandemic, and has been consistent over the past two years as inflation has gone through a normalization process. We’re using not seasonally adjusted data to get a look at the raw readings without any interference from smoothing or adjustments (which don’t seem to entirely remove seasonal forces anyway). There is a case to be made for the “January effect,” which suggests that the first reading of the year typically comes in hot and tends to drop as the year progresses.
Some may call this hopeful, and perhaps it is. The main point being, it’s too soon to freak out and declare that inflation is in fact a major problem again. More importantly, January data tends to cause more freak outs than other months and we should be mindful of that possibility here.
In the coming months, what we’ll be watching is this: What proportion of CPI components are a problem? In other words, how much of the index is still above the 2% target and is that group growing or shrinking?
Since summer 2024, that proportion has grown to 73% of components showing readings above 2%, compared with 60% in July of 2024. Obviously, we want to see this number fall, not rise. But if the proportion of components with problematic inflation readings continues to rise, the Fed and the economy could end up in a very tough spot.
Threshold for Pain
With all of the cross-currents in markets and the unknowns of trade politics, I believe the most important question investors need to ask themselves right now is, “what is my threshold for pain?” I say that because volatility in stocks and bonds is likely here for a while, as is volatility surrounding expectations for Fed policy. That said, most economic fundamentals are solid and there is no obvious or glaring reason to expect that to change at this point. Earnings have come in generally strong for S&P 500 companies thus far, although company outlooks have been more muted and cautious, causing some negative market reactions. Investors are weary of the future, both in the near- and long-term, but the concrete results remain supportive. The days of consistent risk-on multiple expansion are likely behind us given the uncertainty that remains. Portfolios should be diversified among asset classes, including asset classes that can dampen volatility such as cash, gold, and defensive sectors. In a higher for longer rate environment – which seems to look longer every month – valuations should be taken into account as a diversifying element as well. But this is not a signal to run for the hills, this is a warning that we need to keep our antennae up for the major risks that could derail a bull market. I don’t believe this bull is derailed… yet.
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Photo Credit: iStock/Burak Sür
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