Inflation data, usually the Consumer Price Index (CPI), influence the world’s markets and most of its asset classes. It’s one of the most closely watched economic indicators for good reason, because central banks then make interest rate decisions using the latest available data.
When traders monitor the latest CPI data, they’re looking for inflation rate changes that can trigger volatility across markets. That volatility comes with opportunity or, if the trader already has a position, it can be a sign to get out.
As for where that volatility presents itself, it typically emerges in three places:
- Stock indices like the S&P 500.
- Forex trading, especially dollar pairings.
- Bonds, due to reactive central bank policy.
Remember that markets don’t run on hard data alone. While CPI and other inflation metrics are important, the market also reacts to expectations. Whether inflation data is above or below expectations shapes how it is received and how much markets react.
What Is Inflation Rate and Why Do Traders Watch Inflation Data?
Inflation is the measurement of how prices change over time, altering the relationship between money and the products/services it is spent on. When inflation rises, the purchasing power of a currency decreases. When inflation falls, purchasing power increases.
CPI is the most common inflation measurement, reporting data on inflation once a month as part of the Economic Calendar. Derivative traders use a Forex calendar as part of their trading strategy.
Before every release, analysts predict what the data will look like and consequent interest rate adjustments. This leads to the consensus prediction getting priced in.
Markets react most when those predictions fail, and CPI inflation rate is higher or lower than forecast. Banks snap to the appropriate monetary policy as a result, shifting markets.
How Inflation and Interest Rates Affect Financial Markets
As mentioned, central banks set policy based on the consumer inflation rate. They use interest rates to maintain control of inflation, preferring it to be somewhere around 2%. High inflation, very low inflation, and deflation are all causes for concern in the market.
Historically, high inflation rates are the most common. In response, central banks raise interest rates, which makes mortgages and debt more expensive. Conversely, low inflation tends to produce lower interest rates, bringing borrowing costs down.
Like with inflation data, traders should understand interest rate expectations and how they shape the market.
How Inflation Data Moves Forex, Indices and Bonds
After each announcement, the current inflation rate (and reactions to it) will ripple out across the market. For traders, Forex, indices and bonds are the assets to watch.
Forex
Since central banks adjust interest rates based on inflation data, the world’s most traded currencies move too. Currencies strengthen or weaken based on expectations of how the Federal Reserve will handle inflation (their goal being to keep it low), which is in turn based on expectations for inflation.
High inflation actually drives currencies up short-term, so long as the market expects the central banks will raise interest rates in response. This makes a country more attractive for global investors, who’ll trade in the local currency to start investing. When expectations change rapidly, whipsaw patterns can threaten short-term Forex traders.
Stock Indices
Company performance is directly tied to inflation, through their earnings but also through borrowing costs. This means high inflation (so higher interest rates) will get a negative reaction out of the market. It stymies consumer demand, makes debt more costly, and makes lower-risk assets a better alternative for risk-sensitive investors.
Alternatively, lower inflation produces rate cuts that often boost stocks in the short term. It becomes cheaper for companies to take out loans, fund expansion and achieve better earnings, all while consumer spending increases. Index traders try to find the consensus before the real data and policy changes drop, then capitalise on it.
Bonds
Bonds are directly affected by interest rate decisions, so the underlying inflation data plays a big role in setting expectations. Higher rates punish existing bondholders as prices fall and yields rise. Lower rates make bonds more valuable, with higher prices, but the yields fall, so new entrants into the bond market need to pay more upfront.
Bond traders should know that the bond’s maturity length matters. The longer a bond’s maturity, the more price rises after rate cuts and falls after rate hikes, less so than shorter-dated bonds. This happens because longer-term bondholders are locked into a thirty-year cash flow, so it’d take a bigger market move to bring them in line with new market yields.
How Traders Prepare for Inflation Announcements
Inflation data announcements are a regular part of event-driven trading. In the run-up to the announcement, traders should:
- Check their economic calendar for the announcement day and possible coinciding events.
- Know that forecasts aren’t data (and vice versa), and know how to read them.
- Expect more volatility, no matter the current inflation rate.
- Take steps to manage risk.
Depending on the exact forecasts and your chosen asset class, you’d then stake out your investment while looking to identify support and resistance zones on its chart.
Many traders trade the consensus, for obvious reasons, but some traders who anticipate an upset and a sudden interest rate shift will take the opposing trade.
Inflation Rate and Inflation Data FAQs for Traders
How is Inflation Data Collected?
Agencies like the US Bureau of Labor Statistics track what they call a “basket of goods and services” commonly bought across households. By tracking the price of items in that basket, which includes regular purchases like bread and milk, they can get an idea of how prices are changing and in what direction. The basket itself is updated annually.
What is a Good Inflation Rate?
The biggest central banks (the Federal Reserve and Bank of England) both aim for a 2% target on inflation. Keeping it at 2% prevents deflation and sets a small, predictable standard that the public can prepare for, which stimulates consumer spending.
Are There Other Inflation Measurements?
Yes, the Bureau of Labor Statistics measures inflation through both CPI and Producer Price Index (PPI). PPI doesn’t analyse inflation at the consumer level, instead looking at price changes in domestic producer output.
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