There’s a growing debate amidst the punditry as to whether inflation is transitory and, if so, whether it matters. In an interesting WSJ article yesterday, James Mackintosh notes that “markets are leaving little room for the Fed to be wrong on inflation.”

With stock and bond prices so high relative to historical values, this is undoubtedly true. Mackintosh references Michael Pond, head of global inflation-linked research at Barclays, who recently noted that the Fed was right the last time it bet on inflation being transitory, in 2011. But, it’s important to recognize “why” the Fed was right at that time.

The problem with soaring inflation, of course, is that it can lead to soaring interest rates. Between Jan 2010 and Feb 2011, the 10Y had been averaging a 1.5% spread over CPI. After the Fukushima disaster in March, inflation began to outpace the 10Y — not because inflation rose but because the 10Y plunged due to the disaster and the sharp equity correction which began in July 2011 when US credit was downgraded.

In other words, the equity correction gave interest rates a nudge in the right direction, leading CPI by 7 months at which point the influence of falling oil/gas prices finally began to be felt.  Fukushima and the equity correction produced a sharp decline in interest rates to which inflation eventually “caught down.”

By September, the relationship had flipped and CPI exceeded the 10Y by almost 2% — culminating in a central bank-induced crash in oil/gas prices in 2014-2016. Stocks were protected by the yen carry trade, which central bankers revved up in order to stimulate algorithms to go all-in on stock purchases.

By early 2015, the 10Y was back to a 2% spread over CPI as the oil/gas crash played out. The chart below shows both printed on the same scale.

But, of course, it also illustrates the shocking 3.3% spread between the 10Y and CPI. In Spring 2020, it appeared that the situation would ultimately be rectified by another 2014 or 2018-style crack in oil/gas prices – the point being to keep interest rates from running away from inflation. But, as in 2011-2012, exogenous events did the Fed’s bidding.

The COVID crash crushed interest rates to where the Fed, facing a nearly $30 trillion deficit, would eventually need them. The pandemic also gave the Fed all the ammunition it needed to justify QE so massive that the bond market’s price discovery mechanism was seriously damaged if not destroyed.

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By crushing volatility in the wake of yesterday’s record-setting CPI print, the Fed might have convinced some investors that spiking inflation isn’t a problem – even if it’s not transitory. The charts — and the math — suggest they might become skeptical again very soon.

The departure of CPI from the gasoline delta curve illustrates how inflation is no longer just an oil/gas problem – and thus wouldn’t be “fixed” by a modest decline or leveling off of oil/gas prices.

Can the algos be convinced to ignore both the math and the charts?The 10Y has nearly reached the downside target we’ve maintained for the past couple of months, but would the algos ignore a breakdown?  It seems unlikely.

Of course, there’s a fundamental argument as well. The biggest risk to rising inflation as far as the markets are concerned is higher interest rates. By crushing rates (and shorts) at a time when they would normally be spiking higher, the Fed has seemingly eliminated that threat.

Higher inflation will be hard on working stiffs across the country, of course. Higher car prices, gas, rent, food…the people the Fed swears it cares the most about are the least capable of absorbing these expenses – transitory or not. Unfortunately, the market could care less

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VIX’s collapse continues, putting ES within a few points of its all-time highs. At 15.15, VIX has given up nearly 50% since its May 13 highs and has reached the lowest level since Feb 20, 2020 – just before its ascent to 85.47 less than a month later.

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Does Janet Yellen really believe higher interest rates would be beneficial?

“If we ended up with a slightly higher interest rate environment it would actually be a plus for society’s point of view and the Fed’s point of view,” Yellen told Bloomberg News after returning from a G-7 meeting in Brussels.

This might have been true a few years ago when the national debt was only $10-15 trillion. Approaching $30 trillion, however, it’s not as clear cut.  The next comment was the really ironic one.

“We’ve been fighting inflation that’s too low and interest rates that are too low now for a decade.”

It was Yellen, of course, who with her colleagues at the Fed and former/future Fed chairs, deliberately drove interest rates to historic lows. At no point did they “fight” low interest rates. Why would she say such a thing?

1. With inflation on the rise, it is becoming more and more expensive to pin interest rates at an absurdly low level.
2. The Fed has painted itself into a corner, having practically exhausted the lower/longer meme and the obvious bubbles it has blown.
3. If they can back it up with stock manipulation, shifting the narrative to higher interest rates being good could actually reassure investors – the central banker equivalent of “I meant to fall flat on my face.”

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We’ve heard the Fed’s pitches about inflation being transitory, the overriding need to keep stimulus flowing and interest rates at all-time lows, etc. But, as we witness the ongoing Gamestopification of the market, will investors be able to ignore next week’s evidence of persistent inflation that the Fed’s own actions has produced? I think they might need some new slogans.

Futures are off moderately on – drumroll please – better than expected ADP employment and initial claims.

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All ES needed was a 3-day weekend – and, another timely reversal in VIX, another timely breakout in USDJPY, and another threatened breakout by CL/RB – and here we are, 10 lousy points away from new all-time highs.

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