The good thing about getting big surprises in economic data is that it helps reveal the market’s invisible hand. It shows where traders are offsides and helps clarify cause and effect in markets. Yesterday’s hot CPI was about as good an example as one can ask for.
People will fall over themselves right now to tell you how much of the inflation came from items like used cars that are likely to be one-time and Covid-specific in nature. That’s not the most important thing. What’s important is that economists were expecting inflation to decline on a month-over-month basis, from 0.6% to 0.5%. Instead, it jumped to 0.9%.
The definition of transitory is: not permanent. I.e., something that goes away. Economists were expecting inflation to lessen from May to June. They expected it to start going away. To be transitory. It did not. It did the opposite. There’s no tricks in this logic. That’s much different than if they expected it to get bigger and it was even bigger than expected. No, they expected its rate of change to slow, but it accelerated.
The reaction to this rising number was more flattening of the yield curve, albeit quite marginal (and later reversed due to a bad 30-year Treasury auction).
We still got a huge piece of information.
Short-term bonds more directly linked to Fed policy spiked after inflation, with the 2-year yield hanging onto its elevated trading range since the Fed got more hawkish in June. The five-year yield gave a lot back, but still settled higher before ripping again after the bad auction.
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It doesn’t matter if stuff like used cars drove the print. What matters is that short rates popped, giving a nod to tightening, and long bonds stayed firm. The bond market confirmed this was not evidence for transitory, and the result was the exact same thing we’ve been dealing with for more than a month.
It’s as good of evidence we’re going to get that recent yield-curve flattening is more about the bond market pricing in economic tightening than it is a reflection of long-term interest rates on the 10 and 30-year tenors. If the market were optimistic that inflation is a short-lived problem that will give way to long-term growth, we’d more likely see the dynamic we got on the day of the actual FOMC: a bear flattener in which short rates popped the most and long rates rose less.
This isn’t the only evidence that curve flattening is about reduced growth prospects. There’s alarming deterioration in the economically dependent sectors of the stock market. The Covid Delta variant could be playing a role here, but without any major change in hospitalizations or travel behavior, it’s not a great answer. And then there’s the dollar. The dollar refuses to back away from its post-FOMC bounce, even in the face of hawkish moves by other central banks like the Bank of Canada and Royal Bank of New Zealand.
It all fits together quite well, with the seeming exception of one major player: The Nasdaq 100 Index.
Or not. Investors have been indoctrinated to believe lower yields are the recipe for higher stocks. The correlation between stocks and bonds is now at its highest in 20 years. But not all low yields are the same. They used to be low because inflation was low. What I’m saying here is that I think today they’re low because inflation is already an issue. If that’s the case, maybe Powell won’t have to do any tightening himself — perhaps bonds know the stock market will do it for him.
Stocks loved low yields for a long time because it meant the “Goldilocks” environment of low growth but low inflation, buttressed by an accommodative Fed. Today, it’s the opposite. Growth is here but bonds are telling us it’s already being complicated by inflation, tightening, or some combination of both. Yields soared at the start of the year because Powell’s AIT framework left open the possibility of hyperinflation. If he were to go that route today, with CPI at 5.5%, yields could go ballistic. Something’s gotta break.