U.S. consumer prices rose less than expected in December, a report revealed this week, signaling a potential cooling of inflation pressures. I’ll describe a trade that’s a bet on further tame inflation and a drop in rates. The core consumer price index (CPI), which excludes volatile food and energy prices, increased by 0.2%, down from 0.3% over the previous four months, marking the first decrease in the rate of core CPI growth in six months, driven by lower hotel prices, slower increases in medical care costs, and moderate rent growth. The data renewed hopes that the Federal Reserve might ease interest rates sooner than anticipated. Before the report, most expected rate cuts would occur in the year’s second half — if at all. Wednesday’s data renewed hopes for two cuts this year and even the possibility that the Fed could cut in March. Treasury yields dropped, the S & P 500 rose, and the dollar weakened following the release. Energy accounted for over 40% of the increase in CPI. Key drivers of inflation included food, airfares, and car-related expenses. However, goods prices, excluding food and energy, rose by just 0.1% and used car prices fell. Shelter costs, the largest services category, rose by 0.3%. The report suggests inflation is moderating, but Fed officials have stated they need sustained evidence before altering policy. Wage growth, a key driver of consumer spending, also slowed, with hourly earnings up just 1% year over year — the smallest annual increase since July. The Fed will closely monitor these trends to balance economic growth with its 2% inflation target. The sharp surge in equity prices isn’t surprising, as lower rates are generally bullish for many reasons. When interest rates fall, borrowing becomes cheaper for companies. Stock prices are often valued based on the present value of future earnings or cash flows, discounted by interest rates (discount rate). Lower interest rates reduce the discount rate, increasing the present value of future earnings and making stocks appear more valuable. Lower interest rates make fixed-income investments (like bonds) less attractive due to reduced yields. Investors often shift funds to equities and other higher-return assets, increasing demand for stocks and prices. Falling interest rates usually lead to lower consumer borrowing costs (e.g., mortgages, car loans, and personal loans) and can fuel consumer spending. Central banks typically lower interest rates to stimulate economic growth. A stronger economic outlook supports higher corporate earnings, which drives stock prices higher. Falling interest rates often signal a supportive monetary policy stance, boosting investor confidence. The perception of a more accommodative central bank may create a bullish market sentiment, further driving stock prices upward. The trade The iShares Investment Grade Corporate Bond ETF (LQD) , rallied more than 1% — a relatively sharp move for a bond portfolio, and it traded 3 times the average daily call volume while put volume was over 90% below the 20-day average. The most significant contributor to the unusual volume was a sizeable call-spread trade in June, specifically the June $108/$110 call spread, 8000 of which traded a 63 cents. A buyer of the June call spread is betting LQD could return to $110 or higher, a level it was trading only a month ago, by June expiration. LQD 6M mountain iShares iBoxx $ Investment Grade Corporate Bond ETF, 6 months For those wondering how more accommodative monetary policy might affect your equity portfolio, heed the adage “Don’t fight the Fed.” For those trying to bet on rates, though, consider that given LQD’s duration of about 8 years (its sensitivity to changes in interest rates), a bet that it will rally to $110 or beyond by June is essentially betting 10-year rates will fall roughly 40 basis points or more by then, which makes sense given the US 10-year was at 4.2% in early December. (1 basis point equals 0.01%.) I’ve provided an example of the trade here : Buy LQD June 20 $108 call Sell LQD June 20 $110 call DISCLOSURES: (None) All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
A bet on falling rates and easing inflation using options