Wall Street storms back after US inflation surprise

“Today’s cooler-than-expected CPI reading was a breath of fresh air, but no one should expect the Fed to start cutting rates immediately,” said Ellen Zentner at Morgan Stanley Wealth Management. “The Fed has adopted a wait-and-see posture, and given the uncertainty of how trade and immigration policy will impact the economy, they’re going to want to see more than one month of friendly inflation data.”

The S&P 500 rose 1%. The Nasdaq 100 climbed 1.5%. The Dow Jones Industrial Average gained 0.5%. Tesla Inc. led gains in megacaps. Intel Corp. jumped about 6%. IRobot Corp., a consumer robotics company, plunged 37% after raising a “substantial doubt” about its ability to continue operating.

The yield on 10-year Treasuries advanced three basis points to 4.31%. A dollar gauge rose 0.2%. Germany’s benchmark yields are close to hitting 3% for the first time in almost 18 months as expectations of an historic debt issuance surge weighs on the securities.

Money markets showed traders are still fully pricing in at least two quarter-point interest-rate cuts this year, with the first expected in June.

To David Russell at TradeStation, a June Fed cut is still on the table because inflation continues to moderate, especially the key shelter category.

“The White House and the Fed are breathing a sigh of relief because tariffs didn’t filter through to consumer prices,” he said. This is a positive for investors because a huge amount of negativity is priced into stocks. For the first time in several weeks, we might get a break in the streak of frightening news. The other shoe didn’t drop, and that could be good news for Wall Street. Next week’s Fed meeting got a little less worrisome.”

Today’s inflation release is unambiguously positive for risk assets as there is greater confidence that inflation is not re-accelerating like January’s data showed, which gives policymakers a bit of breathing room and should allow the Fed to loosen policy should signs of labor market weakness emerge, according to Jeff Schulze at ClearBridge Investments.

“However, the Fed will also need to see that inflation expectations are recovering from their recent rise before cutting rates, as a de-anchoring of inflation expectations is what keeps most central bankers up at night, given the challenge it represents to restoring price stability in the future,” he said.

As we entered 2025, investors’ main economic worry centered around reflation. But as the trade war continues to escalate and as economic policy uncertainty continues to rise, that worry has shifted from inflation to the labor market and the economy as a whole, according to Bret Kenwell at eToro.

“In that respect, it will take more than a few reassuring inflation reports to ease investors’ worries,” he said. “Moving forward, the Fed will soon take center stage, but not just for its latest view on inflation. Investors will want to hear the committee’s stance on the economy and the labor market, while they’ll also be on the lookout for the Fed’s quarterly update to its economic projections.”

Goldman Sachs Group Inc. strategists lowered their target for the US equity benchmark, and lifted their view on European earnings, in a further sign of growing skepticism on the outlook for the world’s largest economy.

The bank’s strategists cut the year-end target for the S&P 500 Index to 6,200 from 6,500, implying an 11% gain from Tuesday’s close. The reduction was also in view of declines in the “Magnificent 7” stocks.

“Our revised estimates reflect the recently reduced GDP growth forecast of our US economics team, a higher assumed tariff rate, and higher level of uncertainty that is typically associated with a greater equity risk premium,” strategists including David Kostin and Jenny Ma wrote in a note dated Tuesday.

International stocks can continue outperforming if the US economy slows but avoids a recession, according to Citigroup strategists.

The team led by Beata Manthey says the last time US equities underperformed international peers ~9% into a similarly sized market correction was in 2002

“Historically, when US corrections continue beyond the 10% mark, the US remains the underperformer over the entire correction,” they wrote in a note.

The combined de-grossing activity by hedge funds on Friday and Monday was the largest in four years and ranks among the top events over the past 15 years, according to Goldman Sachs prime desk. Further de-risking isn’t ruled out.

“Through yesterday, our best guess is that we are currently in the middle innings of this episode,” the trading desk says, adding that each event is unique given its drivers and duration.

The unwinds have become broader across regions and sectors, spreading to US technology stocks and European equities, which had not seen risk reduction activity before Friday and Monday. Hedge funds’ net leverage “has fallen sharply over the past few weeks,” according to Goldman, driven in part by increased shorting activity, especially via macro products.

The gradual rise in stock market volatility over the past month has seen the VIX Index futures curve becoming inverted, with front-end contracts significantly moving above the longer end. That backwardation is worth watching.

“One of the signs of market capitulation is extended periods of VIX inversion between first and second month contracts. Backwardation of 10% or more across multiple trading sessions typically indicates oversold territory,” says Garrett DeSimone, head quant at OptionMetrics. March and April contracts are currently about 2 points apart, which is a gap of 10%. “This pattern reflects short-term market panic rather than a systemic liquidity crisis, and subsequent mean reversion,” DeSimone says. “It’s possible the market still has room to bottom out.”

Given volatility is mean-reverting, the currently rich levels would need feeding by sustained large daily moves of 1.5% or more in order to hold the levels. While the CPI print looms large on Wednesday, knock-on effects from systematic buyers — who sold a lot of exposure over the past month — can play out and volatility could return to normalized levels.

The impact of Commodity Trading Advisors on the heavy selling in recent weeks has been well-understood, but other systematic market participants have also been weighing on equities under the radar.

Rebalancing selling flows from leveraged ETFs now stands at $52 billion, over the past month with $16.5 billion on Monday alone, according to a note from Nomura Securities cross-asset strategist Charlie McElligott. That’s the biggest monthly number in his chart going back to 2022.

Realized volatility has moved higher, given the S&P 500 saw nine days with moves exceeding 1% in either direction during the past 20 trading days. As a result, volatility control funds were sold $43.5 billion over the past month, including more than $15 billion on Monday.