Inflation Rate is Rising. Should We Be Alarmed? 

For now, stocks are up, and the stock market is positioning to expect the Fed to raise rates for a longer period of time, but the answer to this question depends on momentum.

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We are almost at the moment. Within a few hours of reading this, you will be able to access the US Consumer Price Index data. There is no doubt that traders are going to be analyzing every piece of data they can for any clues on how the Federal Reserve is likely to proceed with its campaign to raise rates at the end of last year after three consecutive downside surprises. 

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A lot of attention will be paid to this month's print, which is expected to run slightly hotter, rising by 0.5% in January for the largest rise in three months. A renewed upward shift in gasoline prices has largely contributed to the increase in this indicator. For the second consecutive month, the core price gauge, which excludes items such as food and energy, is expected to rise by 0.4%. There would not be much concern if the numbers came in like this if disinflation had not made any great progress, but there would not be any sign of inflationary momentum picking up again. It would be a relief to see that kind of result after the surprisingly strong employment data for January:

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At JPMorgan Chase & Co., a team has figured out how to game the way the figures related to the yearly change in the Consumer price index will be received by the market. 

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It was reported that Trade Algo had scenarios for various outcomes, and how these scenarios would impact the S&P 500, and the firm provided those scenarios. If data were close to expectations, it would be considered as confirming a continued slowdown in inflation, which would result in a fall for bond yields, and a rise in the dollar, whereas tech stocks, would lead to a rise in the US stock market. However, any gains in equity are likely to fade, they warned, “once investors shift their focus to a relatively slow rate of disinflation than the previous two months, where each CPI print saw a decrease of 60 basis points.” Analysts expect inflation to come in between 6.0% and 6.3% (in line with the consensus Trade Algo survey estimate).

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There has been a rush by the market over the last few weeks to get away from bets that inflation will be coming down fast, especially after the job data came out. After the employment report came out, yields on the two-year Treasury note rose to a new high for 2023, climbing 23 basis points in just one week as Fed officials' warnings about further interest rate hikes suddenly became more credible after the employment report came out. It has become clear that traders are reevaluating how high they will rise this year, which has fuelled bets that the Fed will peak at 5.2% in July, up from less than 5% a month ago. 

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It is also important to note that there is no more confidence in swift easing later this year. It is important to note that the implicit rate for the December Federal Open Market Committee meeting, which is derived from the fed funds futures market, has never been higher since the start of the contract, which is determined by the Trade Algo function. Almost at 5%, it seems that there won't be any rate cuts this year as the rate is already close to 5%.

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As a result of the unemployment figures, bond market expectations for inflation have also jumped higher. There has been a significant increase in the breakeven rates over the past couple of months on Treasury inflation-protected securities - that is, the difference between these yields and those on traditional Treasury notes - compared to the levels at which they started in December. There was also an increase in the five-year gauge as well. Based on these measures, the belief that disinflation was a threat to the economy for two months has been swiftly reversed.

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Due to the rapid reset of estimates, it is understandable that the market chatter is now pointing toward an upside surprise. According to Greg Bassuk, president, and chief executive officer of AXS Investments, if the report does indeed turn out to be "firer" than expected, it could shake up the stock market, which according to many has risen too far, too fast, on hopes of a more dovish Federal Reserve.

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There has been a lot of talk about this since the employment data was released. The "collective wisdom" of the market economists in Wall Street, despite the "significant downside risk" of the 0.4% core median, tells us that the risks are heavily skewed to the downside of that figure, according to Alan Ruskin, the macro strategist at Deutsche Bank Research. The markets were looking for growth and inflation trends to be softer than they were before the non-farm payroll report in January, he said, but now that a hot inflation number has been released, although unwelcome, it would at least make it easier to explain what is going on in the economy.

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There is also a need to watch out for noise. According to Stephen Stanley, chief US economist at Santander US Capital Markets LLC, headline printing is expected to increase as fuel prices rise. There was a sharp decline in fuel prices between November and December, but they bottomed out late in the month and began to rise substantially in January. As a result of this increase, he added, the headline inflation rate may have gone up by 0.5%.

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It would seem as though Joe Quinlan, head of CIO Market Strategy for Merrill Lynch and Bank of America Private Bank, believes that if Tuesday's data support the view that inflation will moderate more slowly than expected, then there will be volatility in resetting asset prices: "We are not expecting the Fed to raise rates 50 percent, but 25 percent would be okay. As a result, the market will have to come to terms with pushing out any rate cuts that may occur. 

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Increasing the inflation target is one way the Fed can make its life easier, and spare everyone from suffering a protracted dose of higher inflation for a long period of time. However, Fed speakers make it clear that they intend to stick with their 2% annual growth rate. It will take a lot of hard work, warns Don Rissmiller of Strategas Securities, to get there. The Fed "seems unwilling to take a risk" by waiting to see if wage growth can slow down or stabilize with low unemployment, especially since labor demand is currently greater than supply.

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Wage stickiness contributes to another critical concern for the Fed, which is that inflation expectations in the population may become 'unanchored.' In such conditions, wage demands will be higher, and high inflation forecasts can make self-fulfilling prophecies come true. There is good news on this front on this terrain. New York Fed's "Survey of Consumer Expectations" for January 2023 was released on Monday, and the results show that there are actually very few changes in inflation expectations at the short-, medium-, and long-term horizons as compared to expectations in January 2022. It appears that forecasts have now returned to within the target range after deviating from it for the past three years after deviating far from it in the past.

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What's Driving the Stock Market Up? 

As we enter the new year, the rally remains intact. In spite of the reversal in forecasts for rates, stocks have not been adversely affected by the change in forecasts, with the S&P 500 up 7.76% for 2023, and many other markets around the world doing even better than that. In what way? 

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Certainly, it does not have anything to do with the fact that corporate earnings haven't been good in recent years. As a general rule, Wall Street estimates a quarter rise once the quarter has been completed - it is all part of the physics of a company lowering its expectations in order to set a lower bar for themselves to clear. A very significant exception to the trend has been observed in the fourth quarter of 2022.

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In terms of the norm, this is a very unusual situation. A steady disappointment during earning season, on such a scale, has only happened in the past when the economy has been in recession, facing a financial crisis, or both. This elaborate Credit Suisse chart shows just how unusual a situation such as this is.

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Savita Subramanian, a quantitative strategist at Bank of America, summarizes the process as follows.

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Consumers can avoid a deep earnings recession if they remain resilient. However, earnings announcements themselves don't suggest greater optimism. They point to a downturn.

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The rise in expected interest rates can, however, be perversely positive. Consider a concept called “expected value,” in which all outcomes are multiplied by their probabilities, and then all the outcomes are added up. The expected value of a coin flip with 1 on one side and 2 on the other side, for instance, is 1.5. This is true even though there is no possibility of such an outcome happening. Although the sum of all expectations expressed in the market for the Fed funds rate at the end of the year comes out to a rate of about 5% at the end of the year, up from 4.5% a few weeks ago, this does not mean that anyone actually expects the Fed funds rate to be at these exact levels on December 31st. Rather, there seems to be a good chance that the economy will muddle along without needing to make any cuts, and that rates will fall quickly along with it as well.

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He concluded that we shouldn't believe the gobbledygook that a couple of rate cuts will be priced into December, because the Fed is still "ONLY available to help in the unlikely event of a crash landing" and not "buy into this gobbledygook." It seems to me that strong numbers on employment and services make that crash landing seem less likely — and that should be good news for stocks, even though it also means that rates are on the rise right now.

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Last but not least, liquidity is undoubtedly the single most important reason for the rally. Because more money is floating around, it has to go somewhere, and so it is predictable that a good deal of it will flow into stocks to make a profit. Although there are many sources from which it appears that money is flowing more freely, the most important is undoubtedly the People's Bank of China (PBOC), from which most of the money appears to be flowing. While it is unlikely that China's central bankers are considering the US stock market much when they make their decisions, they have been very helpful in their approach to making those decisions. 

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The US stock market can handle rising rates and falling earnings while the risk of a crash landing remains low. It will be interesting to see how it responds to the January consumer price inflation figures.

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Survival Tips 

Let me recommend a book late in the day. Several years ago, the journalist Tim Marshall published a book called Prisoners of Geography or The Power of Geography. It makes sense to me now that I've read it. The book is a brief and unpretentious but comprehensive explanation of why countries' strategic and political priorities are determined by their geography. In a way, it's fascinating and very useful because we are once again forced to realize how important geopolitics really is.