We’ve been writing about the current inflation problem for years.  In December 2019 for instance [see: Inflation Games], we noted that CPI was about to top 2% again and that this realization had prompted the Fed’s shift from a 2% target to a range in excess of 2% to make up for past shortfalls.

Without harping on geopolitical considerations [see: Coincidences and Consequences] all over again, it’s obvious that the Fed’s effort to keep interest rates low is dependent on keeping inflation under control which, in turn, is dependent on keeping the annual change in gas prices under control.

That is why the Fed is considering formal changes to the way it evaluates inflation as (not) detailed in the official gobbledygook offered last month. It also explains the various comments made by Fed officials – first suggesting that inflation should target a range rather than a specific level (i.e. 2.0%) and more recently suggesting that inflation should be allowed to “run hot.”

CPI crept up to 2.49% over the next several months. But, the correction in oil/gas we had forecast at the time accelerated into a rout thanks to the COVID crash in March-April 2020. Oil and gas prices plunged below zero, and inflation was officially too low again.

By September 2020 [see: Inflation Tops Estimates] however, it became apparent that the subsequent recovery in oil/gas prices would again contribute to CPI rising back over 2% by early 2021. We reiterated this forecast in December [see: Don’t Ignore Inflation],  writing:

…the Fed, for all its heroics in “saving” the economy from the pandemic this year, has backed itself into a corner. 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, the 3-4% CPI it implies (so far) represents a very significant risk to markets…”

By March 2021 CPI had reached 2.62% and, according to our research, was headed much higher unless corrective action was taken. In The Big Picture: Oil and Gas we reiterated the dilemma facing the Fed if oil/gas prices continued to rise.

Given that interest rates are close to zero and must remain near zero out of necessity, and the dramatic increase in oil and gas prices since last April’s crash should result in at least a 40%+ YoY increase, and CPI is very positively correlated with YoY increases in gas prices, and interest rates are very positively correlated with CPI, will politicians and central bankers allow oil/gas prices to remain at these levels? I don’t think so.

While our inflation forecast was spot on, this is where our oil/gas forecast began to miss the mark. In the mid-60s at the time, WTI continued to rise until reaching the mid-80s in late October. The 10Y, however, remained in the 1.2-1.7% range. Bottom line, we had greatly underestimated the Fed’s ability to suppress interest rates during a very sharp rise in inflation.

It is a feat rarely achieved except in situations such as 2007-2008 when the equity market crash caused investors to flee stocks for bonds. With multiple rounds of QE at its disposal, the Fed was able to capitalize on the declines the financial crisis had wrought. Like the BoJ and ECB, the Fed had broken the bond market.

With no price discovery to worry about, the Fed was seemingly free to pump equity markets higher without consequence. Until now.

continued for members…

TNX recently had a chance to break out and complete an Inverted H&S Pattern which targets 3.2%. Instead, it reversed lower – a sure sign, IMO, that the Fed is worried about rates keeping pace with inflation.

From a charting standpoint, there are three primary outcomes in such a situation. First, we get an equity correction strong enough to force interest rates lower. The rising purple channel looks to be a good choice and doesn’t reach the top of the falling yellow channel – the one which must not be breeched –  until May 2023. It could accommodate a drop to 0.92% in the next week or two.

Second, that the Fed loses control of the bond market, the IH&S plays out and rates pop up to the falling white channel top (2.65%) or higher.  While I can see TNX reaching the channel top, I can’t imagine the Fed allowing it to break out. Even with an accelerated taper, they can still manipulate prices.

Third, we get a serious equity correction that causes the rising purple channel to break down and rates to drop to the white 1.618 extension (.154%) or lower. While satisfying to the bears, the Fed’s style has more recently been to string out potential market-moving actions as long as possible.

If I were FOMC chairman for the day, I would stick with the rising purple channel as long as possible and work on getting a correction in oil/gas that would take pressure off. With any luck, inflation would be back down around 2% by the time the taper finishes, thereby eliminating any expectations of a rate hike.

The rest of the market could see some major moves as well.

SI made it official today, reaching our 21.51 target from a few months ago. I would hesitate to play the bounce. One chart that must break down if CPI is going to go very much lower… stay tuned…

UPDATE:  1:30 PM

Stocks have held the purple channel midline so far. If they are to avoid a serious decline, look for VIX to play a pivotal role.  The SMA10 is now only slightly above the SMA20.  A plunge below both would be a strong bullish signal to algos.