This morning’s CPI release came in under the expectation, 0.0% vs. 0.2% expected vs. 0.5% expected by myself. The bigger surprise was the miss in the Core CPI (excluding food/energy) where we saw an increase in consumer prices of 0.3% vs. 0.5% expected. As anyone would have guessed, a weaker-than-anticipated CPI kicked off a party in the US stock market this morning as investors can now start prematurely pricing-in only a 50 bps interest rate increase by the Fed in their next meeting. The fact the S&P 500 is trading 1.5% higher intra-day on expectations of 0.25% less of a rate hike in September reiterates how fragile the market is and demonstrates its dependency on low interest rates.
Now that investors don’t need to worry about inflation for at least another month, they now have to shift their attention towards the flashing recession warning signs happening all over the place. The first of those signs has been occurring in the bond market, as shown in the repost from Lyn Alden below:
A 10-2 year yield curve inversion is one of the most accurate recession warning signs dating back over the past century. What a yield curve inversion generally signals to us about current market sentiment is that investors believe that long-term outlook is negative and growth in the economy is expected to slow. I have been saying all along, this is not your great-grandparent’s Great Depression in the sense that all economic activity will cease to exist. It is also not your parent’s Great Recession of 2008, because prices will not decline on a relative basis and the labor market will not freeze to the extent in which it did in the aftermath of the Financial Crisis. Instead, this next 5-10 year period will look exactly like the decade of the 1970s. The 10-2 year yield curve is closely resembling the yield curve of 1981 for a reason. During that year, the economy was also trying to recover from double-digit inflation and was dealing with a Fed Funds Rate of 20%. Even if the Fed Funds Rate only goes to 4-5% in the recession we’re in now, the market will eventually force interest rates way higher in the bond market, because inflation needs to get priced in there. But we can’t have substantial earnings misses for companies such as AAPL 0.00%↑ / PG 0.00%↑ / JNJ 0.00%↑ / MCD 0.00%↑ of other big market cap stocks in an inflationary environment because the inflation itself is propping up corporate revenues. Most earnings misses are going to come in the next several quarters simply because of revenue misses alone, but because of profit margins shrinking with slightly lower revenues. The economy is slowing, but the flow of money is not, because the Fed has not raised interest rates enough to slow the velocity of money in the economy.
It’s important to remember that although consumer prices according to the CPI measurement did not increase nor decrease in July, prices are still 8.5% higher this July than they were last July. Middle-class Americans are still dealing with much higher prices, and it is consuming more of their household budgets than ever before. Apparently, investors are under the false impression that the Fed’s inflation fight is practically over. A few more measly 50 bps rate hikes and inflation will have been killed. No need for the Fed to shrink its gigantically bloated $9 Trillion balance sheet, no need to create demand destruction, no need to stop government excess spending, no need to shrink the supply of credit, no need for any of it. We had the worst inflation since the 1970s and all it took to stop it was bringing interest rates from 0% to 2.50%… yeah right.
Of course this is all misguided false confidence. The bond market remains a deer in the headlights with the Fed about to start shrinking its balance sheet more quickly in September. That means higher bond interest rates, which will put more pressure on stock prices. As for the commodities market, it seems that gold and oil have been looking more forward to those higher bond yields and pricing in those higher rates. Which means, if the Fed fails to sharpen the pace of its Quantitative Tightening program, commodities will need to start pricing out those potential rate increases, and inflation will kick-off the next leg in what I still believe is a commodity super-cycle. Still, oil is struggling today on both higher Crude Inventories and on the idea that we are in a recession that may in fact deepen. That is keeping demand somewhat lower for oil, but remember long-term supply in the oil market remains extremely constrained. You could make the same exact cases for gold. Demand for gold as a monetary asset has been waning as the general consensus among investors is that peak inflation has already occurred. I am going to go out on a limb here and say that the US Dollar Index has peaked.
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