I posted yesterday that this morning’s CPI release would be an “order of magnitude” more significant for markets than the midterm seasonality financial media were touting, and a little victory lap is in order. The CPI came in at 7.7% yoy versus expectations of 7.9%, good for a thousand point surge in the Dow Jones Industrials. But as good as the portfolio numbers feel, the economic implications are nothing to celebrate. Yes, it does confirm my long held view that the Fed is making meaningful progress on quelling consumer price inflation, but the rally the media are so keen to celebrate represents a decline in the market value of the dollar, at cross purposes with reducing consumer price inflation going forward.
The irony of celebrating progress on inflation with a renewed burst of inflation should be lost on no one.
Dollar denominated price increases affected assets across the board. Not only did stock prices rise, but Treasury prices soared, oil surged, copper spiked, silver, platinum, gold, foreign stocks, foreign currencies … which as I have pointed out ad nauseum, can mean only one thing … the market value of the one thing they all have in common – the chosen measuring unit – USD – fell. This is exactly what the Fed does not want to see in its effort to tame inflation. As it has come to recognize, the loss of currency value reflected in rising asset prices prefigures its loss in rising consumer prices.
So while the immediate effect has been to increase market odds of a 50 bp hike in December at the expense of a 75 bp hike, it merely represents a time shift in the distribution of hikes. While it is still possible the Fed will hike 75 bp December 14 (there is still quite a bit more data to be released by then), the effect on the “terminal rate” is de minimus. I would prefer the FOMC hike 75 bp in December and then enter wait-and-see mode, but more likely we’ll see 50 in December and 25 in January. The resultant 4.50% floor is the same either way, and it really makes little difference whether it’s achieved via 75 or 50+25 bp.
This dollar collapse – asset price surge however negates all of the anticipated net easing benefit that the softer-than-expected CPI might have reflected.
As far as our market outlook goes, it appears my comment of October 27 about the bond market inflection is being vindicated. Treasury bonds bottomed on October 24, scarcely three weeks after the October 1 date Synthetic Systems had pegged. Not bad for a turn that it had called as long as two years ago. Yet our trophy is tarnished a bit by the failure of stocks to decline in opposition … in other words it’s still all about the dollar … the divergence between stocks on one hand and bonds and gold on the other remains elusive.
Best assessment at this point is that while it could still come this quarter, it could just as easily be deferred into next year. The lagged effects of the increases in rates and yields are nearly certain to produce a “recession” (which due to the fuzzy and unmeaningful for investors way conventional economics defines it, I will define to mean a “recession” in stock prices). The Fed will be cutting rates, bond yields will decline, bond prices will rise, and gold prices will rise. What I do not expect, however, is for the path to be smooth. Rather it will be lumpy … the anticipated outperformance of gold and Treasuries over the next few quarters will come in chunks as stock rallies such as the one we’re seeing now punctuate periods of sharp selloffs, with both bonds and gold likely rising not only relative to stocks but in dollar terms as well. In other words, it won’t be about the dollar any more … the period of unusual dollar strength is likely behind us and the fondness for cash I have cited for most of this year is as well.
So for bonds, the bear market that began in mid-2020 appears to be over. The bear market in gold, which appears to have bottomed on November 3, likely is as well. I believe these are each beginning a new bull market.
For stocks, the bear market continues. Meanwhile … enjoy the halftime show!
I’m under the impression that most regular readers by now are on board with my interpretation of across-the-board changes in asset prices as reflecting changes in the value of the unit of measure – the currency. As a quick catch up for those new to Financology, consider for a moment the impact of a surge in asset prices (in dollar terms) like we are seeing today. Stocks, bonds, commodities … everything up 2%-4%.
Are there 2%-4% more goods and services available now than 24 hours ago? Of course not. The net result of such a move can therefore only reflect a shift in purchasing power from the dollar to other assets.
Because their owners use these other assets mostly as longer term stores of value, these shifts naturally don’t show up immediately in goods and services prices. But as they accumulate, pass-through is inevitable. Declines in the value of the dollar – inflation – show up first in asset prices, later in consumer prices.
Wolf Richter of Wolf Street points out that the improvement in yesterday’s CPI report was due to a statistical quirk:
https://wolfstreet.com/2022/11/10/services-inflation-spiked-to-second-highest-in-4-decades-would-have-hit-new-high-if-not-slowed-by-biggest-ever-adjustment-of-health-insurance-cpi/
This does not appear to have been factored in by markets starved for any hint of good news. But as Wolf also notes, this adjustment is not used in the PCE deflator the Fed follows. The PCE report is due December 1, before the Fed’s December 14 meeting … an important one of those data points the Fed will have between now and then.
Another one is the path of asset prices. As discussed in the post, the plunge in the dollar and across-the-board surge in asset prices works at cross purposes with the Fed’s inflation goals. Powell must have been pulling his hair out yesterday. This in turn calls into question the markets’ conclusion that a 75 bp December hike is off the table. There’s little question the FOMC would prefer to taper the pace of tightening, but there’s also little question that the Fed wants to see “tighter financial conditions” and that stock prices are another important one of those data points. 75 bp is still in play, and we should not be surprised if in the coming days Fed speakers push back on the markets’ premise of an impending dovish “pivot”.
Quite possible the halftime show is over and the third quarter kickoff has arrived. Market action in the few days since this post further reinforces my view that the major trend change SS had penciled in for around October 1 took place on October 24.
Since bottoming on October 24, EDV, the ETF that most closely tracks the SS Bonds plot, has risen 14.2% from $73.68 to $84.14, outpacing the rise in the world stock index fund VT of 7.4% from $82.12 to $88.18, as well as the S&P’s 4.4% rise.
(Note besides EDV, VGLT and TLT are also reasonable proxies for SS Bonds. All three are concentrated, volatile, and useful in small amounts. In practice I typically prefer a larger allocation to the broader and milder GOVT.)
Murkifiying matters a bit has been the large higher frequency signal superimposed on the major trend in stocks. On stock market charts (I prefer VT, but the S&P will do) the former appears as a zigzag alternately swinging up for a few weeks then down, etc. This is an area well suited to traditional technical analysis … it’s the pattern of bouncing back and forth between fairly well defined upper and lower bounds of a descending trend channel, clearly visible on a one-two year chart. The major trend is the channel itself. Although SS doesn’t resolve the zigzag, the channel is tracking SS well.
I continue to overweight gold and treasuries and underweight stocks. Again, the USD (cash) overweight I’ve liked since January is now past its sell by date. A little excess cash isn’t imprudent, but I prefer bonds and gold.
What would invalidate this hypothesis? If within the next few days VT were to decisively punch through 90-91, or GOVT to fall below around 22.10-22.20, neither of which appears likely, especially the latter. In which case the turn will be postponed for at least a few more weeks. In S&P terms, I’d look for 4100-4200 before concluding halftime is going into overtime.