Don’t Ignore Inflation

Though CPI came in hot yesterday (0.2% versus 0.1% consensus) it scarcely merited a mention in the financial press. In my opinion, this is a mistake. Inflation drives interest rates which, given that debt has topped $27 trillion and 136% of GDP, remains an extremely important consideration.

Though the official data is fundamentally flawed, inflation is the bedrock of my economic analysis. From it, we can forecast not only interest rates, but oil, gas, currencies and equities.  The current analysis begins with the basic assumption that the Fed, for all its heroics in “saving” the economy from the pandemic this year, has backed itself into a corner.

The lion’s share of equities’ rally has been multiple expansion prompted by both a dramatic decrease in interest rates and by plugging a $3 trillion hole with $5 trillion of stimulus.  The 10Y, hovering just under 1%, was nearly 2% a year ago and over 3% two years ago.

Two years ago, SPX dropped as low as 2346 on December 24. It recently tagged 3720, a 58% increase despite a deep recession and an incredible pandemic.  The benefit of the decline in the 10Y is obvious to a point – February 2020. Once equities crashed, yields plummeted as bonds were panic bid.

Since equities’ bottom in March, low yields have helped justify the continuing multiple expansion. Though the gradual rise in yields is important.  More on this shortly.

A similar pattern can be seen with the 2Y, which fell from nearly 3% in November 2018 to 11 bps earlier this year.When it comes to understanding and forecasting inflation, few inputs are as important to the monthly swings as the changes in the price of oil and gas. The monthly data rarely diverge.

Nor do the annual data – though it’s impossible to ignore the divergence of the past few months. In a vacuum, this might be a non-event. But, $27 trillion in debt in a market dependent on historically low interest rates is hardly a vacuum.What the markets don’t seem to appreciate is the implication of the coming spike in YoY price changes in oil and gas. In my estimation, it represents a significant risk to markets and is the chief reason behind the Fed’s recent changes in posture towards inflation.

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