By DailyFX – How Did the Markets React? The build up in the markets over the past three sessions suggested that todays, final inflation report… … was the climax to a fundamentally dense week.

Octobers consumer price index has held up as the weather vane for the Federal Reserves
policy stance through the 17 consecutive rate hikes and beyond. In just the past
few weeks though, the decade-high 2.9 percent pace of price growth in the core
annual figure has received particular attention. Before todays numbers hit the
wires, the markets were already astutely aware of sharp contraction in headline
reads that have backed off with volatile energy prices. Therefore, traders were
left to wait and see whether the core measurement would follow suit; and in turn
encourage the Board of Directors to soften their hawkish eye on a potential rebound
in volatile inflation components and focus on the downturn in economic expansion
instead. Speculation leading into the early release was already tinted with a
negative skew with import and producer price gauges dropping before it. When the
annual figure finally printed at 2.7 percent, relief rallies were seen in
Treasuries, equities and the EURUSD. However the modest turning point for
commentary and the exuberance across the markets quickly died down. After this big
let down, investors were left with a number of indicators to revive the initial run,
but each printed near its respective consensus and allowed the different markets
pursue their own paths.

Bonds – US 10-Year Treasury Notes

After trading within a tight range following yesterdays Empire Manufacturing
data, bonds suddenly gapped higher through this mornings inflation report. The
instantaneous move was so pronounced that it nearly surpassed the previous spike
high, but a subsequent sell-off saw the Treasury note considerably off of its recent
highs. Indeed, the chart below shows that the initial move was not sustained and
fixed income issues sold off in the moments that followed. The incredibly volatile
price moves clearly show that markets were surprised by headline year-on-year
inflation at 4-year lows, but a more thorough examination of the data showed that
initial bond trader exuberance was somewhat unfounded. The subsequent correction in
bond prices marked the third consecutive lower peak in as many days. If bonds are to
continue to make lower highs, we could see higher bond yields boost the domestic
currency, leading to resurgence in US dollar strength.

FX – EUR/USD

The currency market reaction was nearly identical to that seen in bonds, as an
instantaneous dollar decline was met with an equally powerful correction. Extreme
volatility was a clear sign that markets had been highly anticipating a reason to
send the Greenback lower, but cooler heads prevailed as price action quieted through
later trading. Of great significance, markets initially thought that the
exceptionally low 1.3 percent headline inflation number would provide impetus for
the US Federal Reserve to lower interest rates in the medium term. A closer
examination of the mornings news release showed that true inflation remained
high, however, with the closely-watched core number at 2.7 percent. Furthermore,
subsequent Federal Reserve commentary tempered hopes that falling inflation would
limit the likelihood of further interest rate increases. Chicago Fed President
Michael Moskow told reporters, One month doesnt make a trend, emphasizing
continued risks to inflation. Given that he is a voting member of the Federal Open
Market Committee, Moskows words reverberated through financial markets and sent
the US dollar higher in their wake. He likewise added, [Inflation] is moving in
the right direction. The key is whether this can be sustained. Clearly,
Moskows comments emphasize the importance of subsequent economic data.

Equities – S&P 500 Index Futures

Another day, another high for the broad stock indices. The Dow Jones Industrial
Average printed yet another record high close by the end of the session. Following
suit, the S&P 500 Index made its own way into finishing out at a fresh five-year
high. Using the S&P 500 futures contracts, it is easy to illustrate the immediate
reaction in the equity crowd to softer inflation. After the various headline CPI
reads reached multi-year lows and the annualized core measurement eased off its
ten-year highs, the futures contract rallied 7.7 points in only 20 minutes. Looking
back, this was the biggest move through the entire US session; and interestingly
enough, it developed during usually illiquid hours. However, the sudden jump could
not carry through into official exchange hours. This suggests that the strong
opening move was more of a relief rally than a true bullish shift in sentiment for
stock traders. Fundamentally, the inflation report was a reliable sign that the Fed
has greater scope for an interest rate cut by the first quarter of 2007. On the
other hand, it had also encouraged little more conviction for the hawks or doves, as
a core 2.7 percent rate is still well beyond the central banks target 2.0 percent
pace of price growth. Furthermore, benchmark equities indices have been struggling
to find the bullish volume needed to support new records. When the day burned on,
the remaining events and releases did little to rouse the markets for another strong
go. Indicators of manufacturing, housing and foreign securities purchases all
printed close to their respective consensus. More specific to the stock market, big
buy out deals and dividend boosts were offset by accounting probes and sales
warnings. Now without a significant economic indicator on board through
Thanksgiving, an extended climb in the S&P 500 and other indices will rely on the
merits of quarterly reports and big mergers.

Regards,

John Kicklighter
Forex Capital Markets
32 Old Slip, 10th Fl
New York, NY 10005
Email: jkicklighter@dailyfx.com

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