The YoY change in gas prices is highly correlated with CPI which, in turn, is highly correlated with interest rates. If December’s headline CPI (due out at 8:30 AM tomorrow) continues to track the YoY increase in gas prices, it could easily top 2.3-2.4%.

What would the impact be on bond yields? And, how would stocks respond? The last time CPI topped 2.5% was in October 2018, marking the beginning of the 20% correction.

continued for members…First, a quick look at futures this morning. ES is up 7.5 points, primarily on the new highs in USDJPY. Note that ES has already backtested its broken purple channel top…

…but SPX has not yet done so.USDJPY is approaching important overhead resistance.A breakout would be quite significant. Remember, the BoJ had no problem letting the USDJPY break out in 2014 when oil/gas broke down. Inflation is much lower now.And, as we’ve discussed, a breakout in USDJPY might be necessary given the likely continued decline in oil/gas.

More after the break. While VIX’s daily chart looks like it recently reached good support and is due for a nice bounce……the 60-min chart is a little less convincing.

We started watching the Dow again when it tagged the red TL from Feb 2019 last week. Each previous time it has dropped back to the SMA200 or, in the case of June 2019, much lower.  Another drop to its SMA200, currently at 26833, would be about 7% and equate to a drop to SPX 3043 — very close to the 2.618 at 3047. We already have a target there.

This raises the question: How will stocks respond to a strong CPI number tomorrow?

The Fed has been commenting at every opportunity that they might let inflation run hot for a while. Though, how likely would that be if rates shot up significantly?

The chart below shows a few periods in the cycle. We’ll look at them in light of what was going on in CPI.  The periods of Nov 1-Apr 30 are highlighted below.

I’d like to start by looking at the 2014-15 period, as that’s the one that produced the first big YoY drop in the cycle and drove CPI below zero. Note that SPX peaked in May 2015, soon after the April CPI of -0.20% was announced.

SPX ricocheted quite a bit, generally responding to CPI which vacillated between good and not so good numbers.  The bottom finally came on Feb 11, 2016, about the same time that Jan CPI was announced at 1.37% – a strong recovery from the 0.46% average of the three previous months.

Although CPI would remain soft through September, in February things were looking up. Stocks and RB were both recovering nicely, an echo of the 2014-2015 pattern.

Note that 10Y rates had dropped pretty dramatically…

…after testing a TL (yellow, below) from 2007. If it hadn’t reversed at that TL, TNX might easily have reached 3.5-3.7%.It’s telling that RB reversed when TNX needed it to – when a breakout was imminent. As we learned in 2018, the market didn’t like the 10Y being over 3% at all.  By preventing/delaying the breakout and tagging the channel top in Oct 2018 instead, the top was limited to 3.25%.

Incidentally, when TNX broke out in November 2016, it was accompanied by a huge spike in USDJPY and a breakdown in VIX. So, stocks were well supported.

Notably, CL and RB continued climbing until TNX reached the top of its falling channel. This allowed the Fed to raise rates as they’d promised to do. Many, including yours truly, believed at the time that the increase was designed to provide the space for a later drop — when faltering markets needed a sudden easing in order to stabilize.

CPI reached 2.07 in December 2016 on its way to 2.74 in Feb 2017, remaining above 2% for all except 4 months until Dec 2018.  For TNX, the turning point came on Oct 5, 2018 — two days after CL and RB had topped out and would begin huge drops: 45% for CL and 42% for RB.

As we’ve discussed many times, it was also two days after Jamal Khashoggi was assassinated at the Saudi embassy in Turkey — giving Trump all the ammunition he needed to pressure the Saudis into crashing oil prices.

CPI, which had reached 2.52% in October, began a swift drop to 1.91% in December and had reached 1.52% in Feb 2019. When it rebounded to 2% in April (reported in May) RB began tanking all over again, falling well below its previous year’s range. This continued to be the case until November, when the YoY drop shrank to 3.2% before spiking to a YoY gain of 9.1% in December.It’s no coincidence that the sub-2% CPI readings in Jun-Sep 2019 aligned with the three Fed rate cuts on Jul 31, Sep 18, and Oct 30. In fact, the sharp YoY drops in gas prices made the rate cuts possible which, in turn, made a year-end rally and new all-time highs possible.

As we’ve discussed before, gas prices are currently about where they were in March 2019.  If the relationship between the cash and futures markets holds and prices remain or return to current levels in March, then the spike in CPI would run its course by Mar/Apr.

I believe the Fed’s goal is to keep rates at or below current levels, meaning that RB would need to revert to flat or negative YoY comparisons. This would imply that RB could continue to repeat the pattern previously seen during those Nov-Apr cycles: a sharp drop followed by a rebound to higher highs. We’re still waiting on that sharp drop.

It would also imply that ZN could quite possibly test the purple channel top it just missed last August (133’055ish) and, if it exceeds that, the former highs at 135’155.Regression analysis based on the data points seen in Jan-Nov 2019 indicate CPI will come in at 2.3%.  I’ll continue this post tomorrow after the official data for December is released.

UPDATE:  Jan 14, 2020

Something came up, and I’m going to have to wrap this Wednesday morning.