Tuesday is poised to unveil a U.S. inflation rate that has not been witnessed for nearly three years: a consumer-price index reflecting approximately 2%.

In the lead-up to January's CPI data, stocks continued to hold steady near all-time highs as of Monday afternoon. The S&P 500 index (SPX) remained above the 5,000 mark, buoyed by increasing confidence in the improvement of inflation. Treasury yields saw minimal movement following a significant surge in recent weeks, driven by stronger-than-anticipated U.S. economic data.

Economists currently project an annual headline CPI rate of 2.9% for January, marking the lowest level since March 2021 and a decline from December's 3.4%. However, analysts suggest that any unexpected persistence of inflation revealed in Tuesday’s report is likely to have the most impact on the bond market.

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Adam Turnquist, Chief Technical Strategist for LPL Financial in Green Bay, Wis., believes that Tuesday's data will simply confirm what the market is already aware of: a downward trend in inflation. He states that any deviations from this trend might generate short-term volatility but will not undermine investors' confidence regarding inflation.

According to Turnquist, "Stocks are poised to perform well if inflation remains in line with or below expectations. In the event of an unexpected outcome, investors may choose to reserve judgment by focusing on specific components of the report, such as shelter, which are anticipated to decrease." He also highlights the potential impact on fixed income investments if inflation surpasses expectations due to a series of positive surprises in the economy. Turnquist adds, "A higher inflation rate would further contribute to the existing upward trajectory of yields. Additionally, the 10-year rate has a strong correlation with the U.S. dollar."

The previous week witnessed an upswing in Treasury yields, marking their most significant weekly gains in three weeks. This followed minor adjustments made to past CPI reports.

Two key indicators, BX:TMUBMUSD02Y and BX:TMUBMUSD10Y, have recently risen to their highest levels since mid-December, while the ICE U.S. Dollar Index DXY has experienced a 1.8% increase this year. In the afternoon trading session, the S&P 500 has leveled off around 5,022, and the Dow Jones Industrial Average has gained over 100 points (or 0.4%).

According to analysts, the stock market is currently incorporating the assumption that inflation is gradually improving. The focus has now shifted to monetary policy, speculating on when the Federal Reserve will decide to lower interest rates and by how much. Observers state that the initial alarm over inflation has diminished significantly. After peaking at 9.1% in June 2022, the annual headline Consumer Price Index (CPI) has consistently decreased to hold steady around 3% for the past seven months. Although Federal Reserve policymakers mainly rely on the Personal Consumption Expenditures (PCE) price index and its core readings that exclude food and energy, they still consider the annual headline CPI due to its potential impact on household expectations.

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Strategist Will Compernolle from FHN Financial in New York mentions that any level below 3% provides a certain level of reassurance. However, he believes that the upcoming data release may not offer the decisive clarity on inflation that the markets are hoping for. Compernolle highlights that disruptions caused by weather and illness in January resulted in changes in consumer spending patterns and limited companies' operational capacities. The combination of these factors makes it unclear how inflation will be affected in the short term. As a result, January's data may not be truly indicative of the longer-term trajectory of inflation.

Despite these uncertainties, it is predicted that the upcoming report will be considered "good enough" and may relieve concerns that inflation is accelerating too rapidly. This sentiment is likely to be reflected in the market's reaction.

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