If you were playing a drinking game this morning keying off the word “transitory” you’d have passed out by now.

Seemingly everyone is talking about inflation these days. They all want to know whether inflation will be transitory (as Jerome Powell repeatedly insists) or persistent. When it comes to markets, this is the wrong question. I’ll explain.

The federal government threw ordinary Americans under the bus 40 years ago when it began altering the process by which inflation is measured and reported [for more, read John Williams’ excellent primer HERE.]  Cost of living increases (and interest rates) have been tied to this muted CPI data, meaning that consumers have had trouble keeping up with actual increases in rent, food, gas, medical care, etc. which have run about 10% lately. It’s a key reason the middle class has been steadily shrinking.

If the Fed/government were determined to keep actual inflation at or near 2%, they would simply limit the increases in oil/gas prices which are largely to blame for runaway inflation as they’ve done quite successfully in the past.

Since CPI data collection and reporting has become so convoluted, though, the MoM and YoY increases in oil/gas prices have been the primary drivers behind the reflation narrative which is responsible for this past year’s margin expansion/recovery. In other words, the Fed has needed these sharp rises in energy prices to avoid disappointingly low inflation.The other issue, of course, is that stock market performance is joined at the hip with oil and gas prices. Crash them, as was done in late 2018 or early 2020, and you’re likely staring down the barrel of a equities correction.

Let them spike higher, though, and you run the risk of soaring inflation and interest rates. At least that’s the way it used to work.

Over the past 10 years, however, there have been many disconnects. Importantly, they have much less to do with the ebbs and flows of economic activity than they do with managing (usually suppressing) interest rates.

Regular readers know that the Fed now faces an important test. Thanks to last year’s crash, April’s YoY increase in gasoline prices should be around 60% and that (after averaging 1.2% since the May 2020 lows) CPI could top 3-3.5%. What might this do to interest rates?

CPI has climbed nearly back to its 2018 highs. But, despite quadrupling over the past year at a rate of increase which has never been seen in our lifetimes……10Y yields (1.6%) are still less than half their 2018 highs (3.25%.) How could this be? Hint: it’s not because the increase in inflation is transitory.

Here’s another little hint.

Bottom line, whether or not inflation is transitory doesn’t matter nearly as much as whether or not the Fed can convince bond investors algos to ignore the sharp rise in inflation that will be reported in two weeks.

  *  *  *

The 10Y has been vitally important to markets and the Fed. So, it wasn’t about to leave things to chance, for instance, when it nearly broke out of a very long-term channel in October 2018. As we expected, oil/gas prices not so mysteriously crashed in the nick of time – causing interest rates to also crater.continued for members…

I have been expecting the same dynamic to play out now. But, oil and gas prices have been stubbornly resilient. As stated earlier, this is partly due to the role they play in the reflation narrative.

But, it is in great part due to the absence of normal market function from the bond market. Let’s take a closer look.

We all remember the effects of the QE which began in late 2008. The Fed pumped a bunch of money into the system and rescued the economy (mostly the banks) from a negative inflation environment. As the Fed’s balance sheet grew, CPI made a series of periodic spikes which topped 2% an. By 2016, it had to choose between returning to/below zero or breaking out. It broke out, which in turn caused the 10Y to break out as well.As noted above, this led to the 10Y reaching the top of a very long-term channel, threatening a very significant breakout. It can be seen in the TNX chart above as well as the chart below.

A breakout of this channel would obviously not bode well for the Fed’s plans to keep rates at a level that would accommodate the government’s deficit spending. Oil was crashed, and yields quickly followed. Had the Fed not stepped in with massive bond buying, 10Y yields would have tagged the bottom of the falling channel in negative territory a few months later.

These are big, dramatic moves with big implications. But, we can see signs of the Fed’s involvement at other less dramatic moments – especially when there are stock prices to consider.

Everybody has seen some version of the chart below illustrating the relationship between the Fed’s balance sheet and stock prices.  Stocks did quite well as long as the BS continued to expand. The only time they faltered was when the BS expansion slowed in 2010 and 2011.

In Jan 2014, the Fed began tapering their asset purchases – officially finishing QE3 in October. Some of the more significant retracements in stocks followed shortly thereafter, with the most volatility occurring as the balance sheet runoff escalated.

When the balance sheet stabilized and the Fed began QE4 in Sep 2019, stocks broke out to new highs which – thanks to COVID – didn’t hold. With the market reeling, the Fed got serious about expanding its balance sheet. The rest, as they say, is history: new highs for stocks… …and moderate interest rates…

…even though inflation is on the rise and will soon test 2011’s highs.  The Fed’s purchases are plenty big enough to artificially suppress interest rates. If they were to taper or halt purchases, we’d likely see an explosion in interest rates.Powell says that he’s not concerned about inflation becoming persistent. But, that’s only because he believes the Fed can continue to monetize the debt and prop up stock and bond prices.