Inflation has been on the forefront of every investor's mind since the market selloff began in March. Of course, rising prices coincided with the Russian invasion of Ukraine, offering the White House a very convenient event to blame all of its inefficient policies and actions on from the past few years. The attack, of course, exacerbated inflation, as various commodity prices squeezed due to concern of supply loss. But it was not the war, and instead the massive boost to money supply growth over the past two years that really caused the surge in consumer and producer prices.
In a desperate attempt to get the economy going post the lockdowns and avoid a systemic collapse of asset prices, the Fed printed close to $6 trillion and global central banks north of $30 trillion just to avoid a recession. Irony has it, that two years after Covid, we are already there.
The long-awaited July consumer price index print came in at 8.5% year-over-year vs. expectations of 8.7%, including the core CPI coming in 0.2% lower than the expected 0.3%. This caused a massive cheer in the market as the dollar fell hard and the S&P 500 and Nasdaq shot higher along with bitcoin.
We may have seen the peak of inflation, and now year-over-year prints may get smaller as the global economy is cooling after the Fed hiking cycle. But it is important to put it in perspective: We are still talking about an 8 handle on the inflation number, and well above the Fed's more comfortable level of 2%-3%. The market has quickly adjusted its expectation of a three-quarter percentage point rate rise for September, lowering it to half a percentage point. But to declare a victory on tackling inflation with the Fed having finished tightening, seems a bit pre-emptive. We know the Fed is way behind the curve of tackling inflation and they may not raise by another three-quarters percentage point, but they will still be raising rates, draining the market of all the excess liquidity.
We are in a quiet August period with most hedge funds having de-risked their portfolios before the summer. When positioning is light and the marginal seller has disappeared, small orders tend to have large, even outsized impacts on an unsuspecting market. The market was very oversold in July as the number of rate hikes priced in the system was at extremes.
No one, including the Fed, knows how much it will need to raise rates. It is, after all, monitoring the data for signals. But when every investor is long the dollar, short the market, the pain trade is usually a grind higher which becomes a self-fulfilling prophecy, compelling the retail and day traders to chase the rally on fear of being left out. The cheers of the market bottoming grow louder and louder. It is a questionable investment environment when the only logic to buy equities is one that includes the Fed pivoting from tightening to easing by boosting stimulus. Traders these days are not used to looking at fundamentals or earnings, but focus only on when the Fed will ease.
Energy was a big contributor to the fall in headline prices as Brent oil is now down 35% or more since its highs reached in April. But buying oil on back of the dollar falling purely because CPI missed is flawed logic, as that would only encourage the Fed to tighten even more. The Fed has printed its way through every problem over the last decade, but this time inflation has been its biggest enemy. It is for this reason the Fed is in a rush to raise rates as much and as fast it can, because it will need some room to cut if this recession gets out of hand next year. It knows it has no choice.
For now, investors may cheer that the pace of inflation increases is slowing down, but it is still increasing, which means the Fed is going to continue to take liquidity out of the system, which implies lower, not higher, asset prices. There is only one reason why the Fed may be forced to pivot earlier than expected, and that is the labor market. It is a shame that nonfarm payrolls came in so much higher at 500,000-plus, giving them no justification to stop tightening. The Fed has to keep going until inflation comes down or until something snaps. The only fear is we may see the latter before the former.
