This morning’s CPI release was much as expected. CPI came in at 6.5% higher than a year ago, while being 0.1% lower than a month ago.
Markets celebrated this confirmation of a reduction in past inflation with a renewed inflationary surge. Even the most speculative of markets, cryptos such as bitcoin, are taking an ominous turn higher.
One of Financology’s perennial theses is that declines in the value of the dollar show up first in real time asset markets, later in goods and services markets. The monthly decline in CPI is a case study of this phenomenon. Stock and bond prices had declined sharply over the past three quarters into a bottom around the beginning of October. In December, the CPI declined.
The market response is a case study in irony. The dollar has since declined across global markets, against bonds, against stocks, against gold. This on a narrative that the softening of official inflation data imply a less hawkish Fed. It’s more than plausible that not only does the February 1 FOMC announcement bring a smaller 25 bp Fed funds hike, but that it is the last of this hiking cycle. But this same increment of dollar decline is an also a new inflationary impulse that will flow into upward pressure on consumer prices in coming months. First the dollar declines in capital markets, later it declines in consumer markets. We saw this vividly in the surge in bonds, stocks, and gold starting in March 2020, followed by a surge in CPI over a year later.
Big picture: We had inflation in 2020-2021, deflation in 2022. Now we’re back to inflation again.
What could intervene? If the dollar were to resume its ascent in real time markets, that is, if asset prices again reverse lower before the effect flows all the way through the pricing chain, progress on consumer price inflation could be maintained. This could happen in any of multiple ways, but one is that a moderately hotter CPI could trigger another asset price decline. It could also be that the tightening that has already taken place finally takes its toll on corporate profits or that somebody gets too bullish on asset prices (bearish on dollars), becomes overleveraged (shorts dollars), and triggers a “financial crisis” (short squeeze).
This could finally end this cycle of consumer inflation. Followed by another domino of irony, resulting in a mental all clear for the Fed to slash rates and resume printing money, kicking off the next cycle of inflation.
So what’s this all mean for the markets over the coming weeks and months? For now, bullish. We have a profoundly inverted yield curve. This is historically very bearish for stock prices. But increasing short term interest rates are broadly bullish for stocks. The difference is in the timing. An inverted yield curve is not an immediate bearish omen for stocks … the big trouble typically comes in when the yield curve uninverts. First long rates decline (prices rise), inverting the curve, then short rates decline, univerting the curve. Both phases are bullish for bonds, but only the first is bullish for stocks. The second phase has brought the deep declines in stock prices. So I believe my Novermber suggestion that the bear market’s half time show was over was premature … it is still running. Think of when the three month Treasury yield stops rising as a first warning, and when it starts falling as the second.
I can’t emphasize strongly enough, however, that what “stocks” are doing is not an absolute reality. While stocks are “up” in terms of dollars, they’ve sold off sharply in terms of gold, and in fact are back near their October lows. So looked at more critically, what we’ve seen isn’t bullish stock action, but bearish dollar action … aka inflation.
What happens if stocks don’t resume the bear market? This is the Catch 22. If this is a new bull market, consumer price inflation will turn up again, powerfully. This triggers a decline in stock prices … which is reminiscent of the logical exercise known as proof by contradiction … assuming the premise leads to paradox. So while we can’t confidently predict the timing of the second half kickoff, we can be pretty confident it’s still out there waiting…