December’s CPI data shows modest inflation increases, aligning with market expectations. Bonds and equities reflect bullish sentiment as the Fed is likely to hold rates. Sector performance is mixed, with inflation-sensitive industries showing varying trends ahead of the FOMC meeting.

The latest Consumer Price Index (CPI) forecast shows a 0.3% increase in December, leading to a slight uptick in the annual inflation rate to 2.8% from 2.7% in November. The core inflation measure, which excludes volatile food and energy prices, rose by 0.2% in December, keeping the annual rate steady at 3.3%.

The Federal Reserve will meet at the end of the month, and Wednesday's CPI release is the last major economic data point before the meeting. Markets are pricing in a 97% chance that the Fed will not change interest rates, with the federal funds rate expected to remain between 4.25% and 4.50%.

Short interest in long bonds has been falling, indicating a lack of concern about rising long-term rates. At the same time, short interest in short-dated ETFs has been rising, reflecting concern about rising short-term rates. The short position in these ETFs is up by 50%.

The yield curve is firmly upward sloping and has been for a month. The recent tilt in the short-dated ETF market suggests expectations of higher short-term rates and lower long-term rates, or a flatter yield curve.

The SPY short interest has also been falling, showing a reversal pattern, with buying occurring as the price decreases.

This strategy is typical for S&P: shorting on the way up and covering on the way down.

Both long bonds and the S&P have lower short interest, representing bullish sentiment for both. Typically, on FOMC meeting days, bonds and stocks move in opposite directions, but now they are moving in the same direction.

Except for short-dated treasury ETFs, market sentiment is generally bullish. However, with a 97% chance that the Fed will keep rates unchanged, the sentiment is not primarily focused on the Fed and CPI.

Inflation-Sensitive Sectors:

Inflation Up: Energy (Energy Select Sector SPDR Fund XLE): The sector has been rising after a decline, with short interest falling, indicating a bullish stance on both energy and inflation.

Health (Health Care Select Sector SPDR Fund XLV): Stocks are up, and short interest is down, indicating bullish sentiment and expectations of rising inflation.

Inflation Down: Financials (Financial Select Sector SPRD Fund XLF): The sector is down, and short interest is also decreasing, suggesting a bearish stance on both financials and inflation.

Consumer Staples (Consumer Staple Select Sector Fund XLP): Stocks are down, and short interest is up, indicating a bearish outlook for both staples and inflation.

Industrials (Industrial Select SPDR Fund XLI): Short interest is down, which is bullish, indicating expectations of lower inflation.

Mixed: Cyclical (Consumer Discretionary Select Sector SPDR Fund XLY): Stock prices are down, and short interest is also down, reflecting mixed signals.

There is no clear pattern across sectors, although short positions have been shifting in anticipation of the CPI report.

The market is almost certain that the FOMC will not raise rates. However, if it does occur, it would be a surprise to the market.

The CPI report underscores a stable inflation environment, fostering optimism in bonds and equities. Sector signals vary, reflecting nuanced market expectations. As the FOMC meeting nears, the market’s focus remains on rate stability and inflation-sensitive trends, with short interest dynamics reinforcing bullish momentum across key assets.

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