Crude oil rebounded from yesterday’s dip but holds below $90pb despite the rising tensions, and European futures point to a steady start following a session that came under pressure on Tuesday.

US futures are pointing lower, however, following a volatile session where tech stocks led major indices lower. AMD and Micron were down by more than 10% before recovering part of their losses, while the Nasdaq 100 dipped more than 4% and closed more than 1% lower.

Tech – which has shouldered the market rally so far – is giving signs of exhaustion.

So overall, market nerves look fragile and volatility is rising ahead today’s next big data test: the US CPI update. Early week’s urge to chase a dip could evaporate in the blink of an eye, because:

US inflation seen above 4%

In the particular case of the US, gasoline prices rose by more than 120% at their May peak and remain 80% higher than levels at the start of the year.

Inflation data reacted immediately. Headline CPI spiked to 3.3% a few weeks after the war started, then advanced to 3.8% in April, and the figure is seen crossing the 4% mark in today’s May print. Core inflation, on the other hand, which strips out volatile food and energy prices, may have risen toward the 3% mark as higher energy prices spill over into the broader economy.

What’s important today is that both inflation metrics are significantly higher than the Federal Reserve’s (Fed) 2% inflation target.

Rising inflationary pressures have totally shattered expectations of a Fed rate cut this year. Fed funds futures now price the probability of a Fed hike as soon as October at roughly a coin flip.

And even the new Fed President Kevin Warsh – who is inclined to cut rates and reduce the size of the Fed’s balance sheet – will not be able to cut rates when inflation spikes past 4%.

On a side note, I don’t think he will be able to reduce the size of the balance sheet either. Pulling liquidity out of the market is simply not possible without causing a massive selloff when global financial markets have been enjoying such ample and parabolic liquidity injections since the GFC.

But anyway, without defending him, Warsh initially argued that technological advances and AI would be disinflationary – they would increase productivity, boost supply and therefore pull prices lower in a way that paves the way for structurally lower rates. That thinking certainly holds in the longer run, but in the shorter run we have a problem, Houston: the Middle East war brought a completely unexpected flavour into the mix – a spike in energy prices. And a prolonged period of high energy prices is necessarily inflationary.

Also, the massive AI buildout is also pushing electricity and other raw material costs higher.

So today’s CPI data will be important and closely watched. It will be the last major data point before Kevin Warsh heads into his first FOMC meeting as Fed Chair.

As for the market reaction, a stronger-than-expected set of figures could echo what we saw on Friday following the US jobs data, sending bond yields higher and stock prices lower. The moves could be just as sharp, depending on the data. The market is so crowded with bulls right now that even a small fear could turn into a nightmare.

Figures in line with expectations, or ideally softer than expected, on the other hand, could help avoid another risk selloff, but will hardly reassure those who watch the news beyond technology and AI regarding what’s to come.

In reality, only the end of the Middle East war, the reopening of the Strait of Hormuz, the re-establishment of trade flows and/or a sustainable pullback in global energy prices would mark the end of the current inflationary wave and push the Fed – and other central bank hawks – out of the room.

Dollar’s next direction

In the currency markets, rising oil prices and a hawkish shift in Fed expectations threw a floor under the greenback’s year-long depreciation against most major currencies. However, the fact that the Fed has remained relatively dovish compared to other major central banks, and the broader loss of appetite for US dollars and US Treasuries, kept upside attempts limited even with the ongoing Middle East war.

Forgetting about the war for a second, US growth has been stronger than that of many major economies thanks to massive AI investment and government spending, and the latter could keep dollar bulls somehow motivated as actual valuation levels allow for a further upside correction in the US dollar, without necessarily reversing its longer-term bearish trend. Yet at some point, when the Middle East dust settles, the rate differential between the Fed and the rest will likely weigh on the US dollar and support other G7 currencies.

The million-dollar question is: when will the dust in the Middle East settle?