Inflation Risk is Ignored as Traders Bet on a Smooth Rate Path

With a September rate cut from the Federal Reserve all but guaranteed, options traders are betting on calm waters in the stock market until Thursday’s consumer price index report. But that confidence could prove misplaced if inflation data comes in hotter than expected.

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The reasoning behind expectations for a Fed cut at the Sept. 16–17 policy meeting is straightforward. U.S. job growth has stalled, leaving the economy in need of support.

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The case grew stronger last Friday when weak August payroll numbers and the highest unemployment rate since 2021 led investors to fully price in a quarter-point reduction next week.

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Markets largely took the data in stride. Stocks slipped modestly, while the Cboe Volatility Index (VIX) edged higher but stayed below the 20 mark, where it has lingered since June.

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Looking ahead, options pricing suggests traders expect the S&P 500 to move about 0.7% in either direction after Thursday’s CPI release, according to Piper Sandler data. That’s well below the 1% average realized move seen over the past year.

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The logic makes sense but it leaves one glaring risk: what happens if inflation unexpectedly accelerates?

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“It’s a very fine balance right now,” said Eric Teal, chief investment officer at Comerica Wealth Management. “A sharp surprise, positive or negative, could flip the narrative quickly.”

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A run of hotter inflation prints remains a threat, especially with policy pressures such as trade disputes, mass deportations, and cuts to the federal workforce under President Donald Trump. If price growth proves sticky, the Fed may be forced to slow the pace of cuts, disappointing traders banking on deeper easing.

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“The trajectory for rate cuts could become shallower, which would inject volatility into markets,” warned Sameer Samana, head of global equities and real assets at Wells Fargo Investment Institute.

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Although volatility seems subdued on the surface, markets remain hypersensitive to key economic releases. Over the past three months, the S&P 500 has been nearly 50% more volatile on days featuring CPI, jobs reports, or Fed rate decisions compared with all other sessions, according to Asym 500 data.

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The influx of “macro tourists” short-term traders moving in and out of markets based on economic releases has amplified those swings, said Brian Madden, chief investment officer at First Avenue Investment Counsel.

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With investors pricing in not only a September cut but also roughly 142 basis points of easing over the next year, any sign that inflation is persisting could prompt sharp stock market reversals as traders scale back dovish bets.

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Wall Street is already bracing for that possibility. Economists expect August’s core CPI, which excludes food and energy, to rise 0.3% from the prior month. That would put the annual increase at 3.1% well above the Fed’s 2% target and matching July’s reading.

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“You’re seeing macro factors play a larger role,” said Sadiq Adatia, chief investment officer at BMO Global Asset Management, which oversees C$226 billion ($163 billion). “Long-term investors want the economic data to drive markets. What they don’t want is short-term noise.”

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So far this year, however, markets have often traded more on tariff headlines and political uncertainty than fundamentals, Adatia added.

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Despite these risks, stocks enjoyed a powerful rally this summer. The S&P 500 gained more than 10% between Memorial Day and Labor Day, its third-strongest summer in nearly four decades, according to Raymond James. But while equities have been calm, bond markets are signaling turbulence ahead.

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The VIX, Wall Street’s fear gauge, remains near year-to-date lows. In contrast, the ICE BofA MOVE Index the bond market’s volatility benchmark jumped 10 points over two sessions last week, its biggest two-day rise since April’s tariff turmoil. That surge suggests fixed-income markets are preparing for rougher conditions.

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The ratio between the MOVE Index and the VIX now sits near its lowest level since February, a sign equity traders may soon feel the ripple effects from bonds.

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All this leaves traders closely monitoring fixed-income markets for early warning signs of volatility spilling into stocks.

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“It’s no surprise that markets are reacting more strongly to economic releases during this period of elevated policy uncertainty,” said Mandy Xu, head of derivatives market intelligence at Cboe Global Markets. “A September cut looks like a done deal, but incoming data could reshape expectations about how aggressively the Fed will ease in the months ahead.”

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