Wednesday, February 14, 2018

CPI Worries

I don't recall a time when so much focus was on one CPI number.  It did come in higher than expectations, which has only stoked the flames of inflation concerns in the market.  The stock and bond market correlations have been blown out of the water, with many days when stocks and bonds move down together, and some days when stocks and bonds go in opposite directions.  It is a completely mixed bag at the moment.  Those who have been using bonds as a positive carry hedge against stock market down moves are questioning the strategy. 

Risk parity has been pummeled the last few weeks, and it is all due to the new theme of this market, which is inflation.  The inflation fear has its origins from a weaker dollar, higher oil trend in 2017.  The tax cuts which add at least $1.5 trillion to the deficit passed at the end of last year have added fuel to the inflation fire.  More recently, the reckless government spending continues with a huge $320B addition to the budget for 2018 and 2019, with a permanent increase in the budget caps. 

It is pure politics.  Most Americans don't care about deficits, they care about wages and economic growth, government benefits, and taxes.  Deficits are nearly at the bottom on the priority list.  With lobbyists buying off politicians' votes, there is almost a guarantee that taxes go down and spending goes up.  It is the politically popular thing to do, both among the general public and the lobbyists.  It just happens that the tax cuts and the government spending go straight to the coffers of the lobbyists and power players in Washington DC.  That is why you will continue to see bigger and bigger budget deficits and a huge increase in national debt.  And just like Japan, with their huge budget deficits, the end solution will be a monetization of the debt.  The Fed will have to do another huge QE program to sop up all that Treasury debt and keep interest rates low when the next downturn happens.  And it will happen. 

As I write, the S&P is screaming higher off the panicky open on the high CPI number.  The past few trading days clearly show that investors are adding back risk and feel like Friday's V reversal was the bottom.  While I agree that it is a short term bottom, as I am long, I disagree that it will last more than a couple of weeks.  The market psychology has changed, and the interest rate picture has gotten less favorable.  It will not be shrugged off unless bonds embark on an uptrend.  I see that as being difficult given the events coming up over the next few weeks which will keep fixed income investors nervous.  Powell speaks to Congress on February 28, then the newly feared nonfarm payrolls number on March 2, and then the ECB meets a week after that to probably discuss the end of QE, and then you have Powell's first Fed meeting, with a press conference, where he will be under pressure to be hawkish with these high inflation prints and strong jobs numbers.  That is a murder's row of events for fixed income investors.

So I give this equity rally until next week, and then the nervousness should come back in late February/early March ahead of these events.  And unlike ahead of this CPI, I expect there to be selling ahead of the event, not buying and short covering.

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