Why the lowest inflation reading in 2 years is great news for the stock market

• The June CPI report revealed that inflation has dropped to its lowest level in more than 2 years.
• That's great news for the stock market because it emboldens a soft landing scenario for the economy.
• A "100 point gain [in the S&P 500] could be 'low end' of a potential rally," Fundstrat's Tom Lee said.

The June CPI report revealed that inflation has dropped to its lowest level in more than two years, and that's great news for both the economy and the stock market.

The consumer price index rose just 0.2% in June, below economists' estimates for a 0.3% gain, and rose just 3% on a year-over-year basis, its lowest level since March 2021 and below estimates of a 3.1% gain.

A positive inflation surprise was welcomed by investors on Wednesday, as the Dow Jones, Nasdaq 100, and S&P 500 all surged about 1%. 

Such a strong move higher was no surprise to Fundstrat's Tom Lee, who forecasted at the start of this week that the S&P 500 was poised for a 100 point rally sparked by a better-than-expected inflation reading.

Now Lee is arguing that a 100 point rally in the S&P 500 this week could be on the low end, with a potential rally driving a more than 200 point gain in the index. Such a gain would send the S&P 500 to new 52-week highs.

"Of the last 8 CPI reports, markets had a positive reaction 6 of 8 times. The two 'surprises' saw 4% to 5% rallies, or +180 to 225 points. Thus, our 100 points rally tactical call might be on the low side," Lee said in a Wednesday note to clients.

Such a positive reaction to lower inflation readings is driven by the fact that it emboldens the view of a soft landing scenario in the economy, in which a recession is ultimately avoided despite the aggressive monetary tightening from the Federal Reserve over the past year.

The low inflation reading also gives the Fed more breathing room in its interest rate decisions, with markets currently pricing in only one more interest rate hike for the year. Before the CPI report, the futures market had suggested the Fed might hike rates two more times before year-end.

And low inflation is great for consumers because wage growth is finally starting to outpace the rate of rising prices, which results in real income growth for consumers and gives them more spending power, which drives the bulk of the US economy.

Lee expects June's low inflation reading to continue throughout the summer, which again could embolden bullish investors who are betting that the economy will remain resilient.

"If this CPI print is +0.20% or so, the odds are very high that we will see +0.20% Core CPI prints for each of July and August. That would make three consecutive months where Core inflation is running at 2.0% to 2.5% and would make markets entirely rethink that path of future inflation," Lee said. "It really raises the question whether 'higher for longer' [interest rates] makes sense."