The correction is gathering steam, with ES off 40 points earlier this morning before getting a bounce. From a technical standpoint the culprit is VIX, which broke out of the falling channel which has guided stocks higher since March 2020. 
Our downside targets remain unchanged.
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As we noted yesterday, EURUSD is finally fulfilling our expectation of a breakdown from the trend established at the Mar 2020 lows. This move has been a long time coming and has potentially significant consequences for the DXY.
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ES came within 9 points of our next downside target before getting a nice bounce motivated primarily by USDJPY, which was working flat out to save the NKD from a scary, and long overdue dive to its SMA200.
This bounce will be quite important to the bulls, who are no doubt hoping to avoid a bearish 10/20 cross.
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We’ve pretty much beat the inflation horse to death on these pages over the past six months. Bottom line, It’s too high and potentially out of control.
So far, however, the Fed’s been able to hoodwink investors and algos and commandeer the bond market. Aside from making things much more difficult for the little guy – who they claim to care about – there have been few negative repercussions.
But people are starting to talk. At first it was just fringe strategists like yours truly. Lately, it’s financial pundits, important bankers and hedge fund managers. Has the trance been broken? And, if so, will the market care? Today, we’ll finally find out how clever the Fed can be.
Two years ago, before any of us had ever heard of COVID-19, our charts already called for some pretty dramatic outcomes. We were pretty sure the 10Y, having reversed right on target at 3.25% in October 2018, was headed for at least 1.55%…
…a target that was adjusted to 0.15% — 1.33% on January 13 at which point Wuhan City had reported only 40 suspected cases and one death. On March 8, it reached 0.398% – well ahead of schedule thanks to COVID-19. 
Its rebound has been impressive – aided by a sharp rebound in inflation due primarily to the even more impressive recovery in oil prices.
Ah, oil… We became convinced in March 2018 that oil was headed for a major breakdown, noting important cycles in its peaks and troughs. At the time, our model showed WTI (then at $62) dropping below $20 in early 2023.
On Jan 3, 2020 we got more specific, pinpointing $17.12 on April 23, 2023.
Of course, it dropped much lower and much faster than that. And, it’s recovery has been higher and faster than anyone imagined (or the fundamentals would support.)
Interest rates and oil prices are irrefragably joined at the hip. Gasoline prices are especially highly correlated with inflation… 
…which has traditionally been highly correlated with interest rates. But, that all changed in the last couple of months when, thanks to the Fed’s ability to control interest rates, the bond market stopped caring about inflation.
The stock market was elated as short rates flatlined while the 10Y marched higher…
…leading to the first time in 20 years that a rapidly rising 2s10s didn’t lead to a market crash.
The Fed has pulled off a pretty masterful reinflation of the everything bubble. Are they clever enough to avoid the inevitable pop?
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You could argue that the annual PCE print of 3.6%, the hottest since 1992, is merely a function of the base effect – last year’s crash in inflation.
But that argument falls flat when you consider that MoM Core PCE, which is completely unaffected by the base effect, soared by a record 0.7%.
Naturally, both stocks and bonds ignored the data. After all, VIX has plunged 36% in the past 7 sessions, so everything must be okay, right?
Not so fast.
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The Dow, the most easily and commonly manipulated index, has gone nowhere since failing to hold its 3.618 Fib extension at 34,430. It begs the question: what’s the holdup?
Usually, when a closely followed index goes sideways for a while, it’s because an important moving average is moving into position for a backtest. But, is that the case here?
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I had an great question yesterday regarding the bond market: “Is it possible the fear of pandemic in spring 2020 affected the behavior of 2yr and 10 yr and then indirectly triggered the crash?”
Pebblewriter longhaulers will recall that our bond cycle model forecast a severe plunge in interest rates long before anyone was talking about a pandemic. In August 2019, for example, we were already anticipating a drop to near or below zero around December 2020.
It’s what the charts suggested, as we posted in April 2018 [see: Bonds – a Buying Opportunity]…
…and it’s what was necessary in order to keep America’s books balanced. Annual debt growth was averaging 5%, and debt:GDP had topped 100% for the past five years.
As we pointed out in July 2019 [see: Why Interest Rates Must Not Rise] the only way to keep debt service from overwhelming other federal expenses had been to crash interest rates.
The trick was how to force interest rates lower without alarming us economist types. Past maneuvers had involved adjusting Fed policy (not terribly effective for medium and long-term rates) and forcing inflation lower by forcing oil and gas prices lower as occurred in 2014-2016 and late 2018 (detrimental to stock prices.)
CPI, which had spent most of 2018 above 2%, had declined to a more manageable 1.7% by September 2019. But, the year-end ramp job in oil prices sent CPI up to a troubling 2.3% by December. The 10Y rose from 1.43% in September to 1.95% in December and, as the chart below shows, threatened to break out. Something, as they say, had to give.
As the big brains at the Eccles Building were spitballing potential solutions, the most extreme case of deus ex machina imaginable landed in their laps. COVID-19 did the Fed a solid – albeit one which went way overboard.
Oil prices, inflation and the 10Y were suddenly in a race to zero (oil won) and the Fed suddenly faced a slightly bigger problem: how to prevent Armageddon. They needed higher oil prices, interest rates and inflation just to talk equity investors (well, algos) off of window ledges.
It worked so spectacularly well that they painted themselves back into a corner very similar to the December 2019 one: rapidly rising inflation and interest rates thanks largely to spiking oil and gas prices – exactly what our models predicted would happen. YoY gas price increases and CPI have been so highly correlated that they are now literally on top of one another.
For the past few thousand years, this would have been a serious problem. Everybody knows interest rates spike when inflation spikes. Since the Fed essentially took over the bond market, however, they’ve been able to convince bond investors (well, algos) that spiking inflation isn’t a problem and, even if it is, it’s transitory.
Want proof? Rates have actually declined since April’s 4.2% CPI print and are nearly back to the same level as before the bomb was dropped.
If I walked up to you on a cloudless day and insisted that shaking my rain stick will make it pour, you’d probably double over with laughter. If I had a secret accomplice spray water from a garden hose all over us from an undisclosed location, you might begin to wonder if I was right.
That’s what’s happening with interest rates right now. Except the rain stick is the Fed’s prognostications and the garden hose is actually a low-flying supertanker carrying 20,000 gallons.
Of course bond investors care about spiking inflation. But, with the Fed pumping billions of dollars into the bond market every day (more on days with alarming economic data) to force interest rates lower, they can claim that said inflation (“did we mention it’s transitory?”) is obviously not a problem. And the dopes in the financial press eat it up because, by God, they’re soaking wet.
Instead of rising, interest rates decline, proving to all (especially the algos) that the Fed must know what they’re talking about or — to us more cynical types — that they’ve completely destroyed the bond market’s price discovery mechanism.
So, did fear of the pandemic affect bond behavior and, thus, cause the crash? Absolutely – though it’s a bit of a chicken and egg situation. Everything unraveled at about the same time in the mother of all negative feedback loops.
The irony is that it accomplished what the Fed needed to happen in the bond market — though to excess. The Fed can now use the pandemic as their excuse for the most rapid expansion of monetary supply in history– even as spiraling inflation crushes the disadvantaged whom the Fed claims it’s desperate to help.
Now, on to the markets. No surprise, but futures managed to ramp higher again overnight – creating the illusion, at least, that the downside case is off the table. 
It’s not.
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Interesting piece in Reuters today on Japan’s vaccination efforts and the overwhelming level of infections in Osaka, Japan’s second largest city, only two months ahead of the Olympics.
While many countries are making good progress with vaccinations, Japan – the 11th most populous country in the world – is lagging badly. It’s not the only country in Asia to be struggling.
A close-up of vaccination rates shows that many Asian countries are in the same boat.
Will the Olympics be the next global superspreader event or, perhaps, the next Tom-Hanks-has-COVID! moment?
Those who have put off getting vaccinated might want to consider the number of daily flights from Osaka to the US…
Meanwhile, futures are paying more attention to the daily pre-opening VIX plunge and a bond market which seemingly no longer cares about inflation.
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It comes as no surprise that PPI confirmed yesterday’s hot CPI print, coming in at a whopping 6.2%.
We’ve been beating the inflation drum for so long, it feels a bit anticlimactic to acknowledge that it’s finally here and even slightly greater than we anticipated.
As regular readers well know, I expected central bankers to preemptively head off the problem of higher inflation and higher interest rates by crashing oil/gas prices as they have many times before.
I was surprised to see them pass on this approach and roll the dice with inflation. But, it made more sense once it became apparent that they had essentially taken control of the bond market – the one market that had always “told the truth” about economic conditions. No more.
As strong as yesterday’s equity selloff was, the 10Y barely budged, rising from a high on Tuesday of 1.63% to a high on Wednesday (after CPI was announced) of 1.69%. Today, yields are actually dropping. An orderly channel like the one below is all you need to confirm that yields are being carefully managed.
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Speaking of carefully managing things…I can only imagine the panic around the Fed, the Treasury and the White House when the Colonial Pipeline fiasco popped up the other day. Higher oil/gas prices had helped get stocks to their recent highs, but it was time for the market’s caretakers to take their feet off the gas lest inflation be even more alarming.
A shutdown of the nation’s largest fuel pipeline certainly wasn’t part of the plan – though I wouldn’t be surprised if the hackers had placed some well-timed bets on oil/gas prices in advance. With markets going crazy over inflation, something had to give.
I had the following conversation on this very topic with a very good friend who happens to be both brilliant and an excellent trader. But, he’s nowhere near as cynical as I am. We chatted just after the close.
Less than ten minutes later…
RBOB futures are off nearly 6% from Friday’s highs.
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With futures having already dipped below the SMA50 to tag a key target earlier this morning, the bounce should continue given the algo action focused on VIX.
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Futures are flat after tumbling to and holding our backtest target yesterday morning. But, pay no attention to stocks just yet. They should continue to be under pressure, with the real action in oil and gas.
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