JPMorgan CEO Jamie Dimon is so worried about inflation he won’t invest the Wall Street bank’s cash. Homebuyers are backing out of the market amid a pricing frenzy and used car sticker shock is now a bigger deal than new car pricing on the dealership lot.
It is not news that inflation is running hot. The May Consumer Price Index spike of over 5% was the highest since 2008. Strip out food and energy prices from that inflation print and it was the highest inflation reading since January 1992. Producer prices, meanwhile, rose at their fastest pace in over a decade. And according to a Federal Reserve Bank of New York survey, consumers fears about inflation are at a record, too.
A good question then: Why is the S&P 500 Index setting new records, the Dow hanging near if now slightly below a post-pandemic rally record, and the Nasdaq coming off a recent seven-day winning streak right before the Fed’s meeting concluded on Wednesday? All three major stock market indices are now between roughly 90% (the Dow) to over 110% (Nasdaq) above their pandemic lows.
For Nick Colas, co-founder of DataTrek Research, all the comparisons between current inflation numbers and records from the past are interesting for market historians, but less relevant to the stock market outlook. Stocks went into the Fed meeting treading water on Wednesday before the open, and then dropped in the afternoon when the Fed revealed a slightly more hawkish stance on raising rates in 2023, and commentary from chairperson Jerome Powell was more attuned to inflation risk, even as the central bank continued to message that inflation was “transitory.”
Stock futures were down slightly after Wednesday’s in-the-red close.
A patient bond market is the key
The reason for his bullish take amid the inflation fears and the number he says that is more important to watch than CPI: the bond market. It is signaling patience.
Even with the hot inflation print Treasury yields remain low. Yes, the inflation numbers can be real — and a valid concern for the bears, especially when they point to prices for homes and rentals — but market historians should also note that the bond market has a history of being slow to react to inflation trends.
The 10- year Treasury yield rose after the Fed meeting, but remains right around 1.5%.
The bond market is not signaling an inflationary environment that is here to stay and Colas is willing to bet that the bond market is a better bettor right now than Jamie Dimon.
“Treasury yields are not wrong,” he said. “If you think [inflation] will come roaring back don’t be in bonds, don’t be in stocks.”
His bullish take on why the bond market is showing patience is that all the factors which are pushing up inflation are transitory in nature, as the Fed has consistently said. That includes used car prices which are spiking not only because fiscal and monetary policy has given car buyers more buying power, but also as a result of the chip shortage in the auto market and less supply of new cars. When short-term factors are stripped out, CPI is actually close to where it was right before the pandemic hit the U.S, a little over the 2% mark from February 2020.
The exception which supports the bears: inflation in home prices and rentals, which could stick and weigh on the economy in a less transient nature.
Housing affordability is among the issues that can test how dovish the Fed remains, Michael Englund, chief economist for Action Economics, told CNBC earlier this year in anticipation of the summer inflation record prints. He said some of the price comparisons may be short-term, and are to be expected given the year-over-year change from the pandemic shutdowns, but home ownership and rental prices are inflationary pressures that make the June and July FOMC meetings, and semiannual monetary policy testimony to Congress on Capitol Hill, events to watch for signs of a potential shift in rhetoric.
Sticking with the transitory inflation argument, “may fall on deaf ears in the summer when the Fed goes before Congress,” Englund told CNBC.
But Colas concludes from that data that while shelter inflation will continue to rise, history says it alone is not enough to keep CPI moving swiftly higher when other factors, including energy, used vehicles, car insurance and airfares — all of which drove the recent increase — are “safely in the transitory inflation camp.”
Cautious on stocks, not panicky on inflation
Yields have retreated from March highs, and that has helped lift the S&P to a new all-time record.
Colas now counts himself cautious on stocks, but not bearish on the market due to fears of a more hawkish Fed.
“We’ve been a touch cautious (but not bearish) on US stocks lately, and a modest new high alone is not enough to shift our view,” he wrote to clients after last week’s CPI. “Clearly, a decent chunk of our ‘no secular inflation’ thesis is already priced into Treasuries. Big Tech should see a small catch-up rally as a result. But as for the next move higher in large caps, we still think that will only happen as companies report Q2 in July and signal their outlook for the rest of 2021.”
His bigger picture view is that while markets can go through short-term periods of panic related to bonds and stocks — the shortest-term being the tendency of stocks to drop during Powell post-Fed meeting commentary — the bond market often takes a long time to really catch up to inflation. Historians can look at every CPI going back to the 1950s if they’d like, but Colas noted that the period he looks to right now is when the U.S. was coming off the last major period of inflation that ended in the 1980s and saw inflation decline from double-digit percentages to 2%. It took the Treasury bond market 20 years to accept that inflation had been beaten in the U.S.
“Bottom line: This is exactly why 10-year Treasuries ignore even 1-2 years of CPI data,” he wrote in a recent note to DataTrek clients.
The lesson: “The Treasury market is a ‘show me’ market,” Colas tells CNBC. “It wants to see inflation go up or down for a long time before it re-prices. … high inflation this year says nothing about the future and before the pandemic, because we had such low inflation, [the bond market] will need a lot of proof before it says inflation is rising again,” Colas said.
Investors do not expect a hawkish Fed
“Predicting inflation basically means predicting interest rates. It’s been a fool’s errand for the last 12 years,” said Mitch Goldberg, president of investment advisory firm ClientFirst Strategy. He expects broader inflation caused by supply imbalances to be transitory and ultimately mitigated by greater production levels globally, while wage inflation may prove stickier, but manageable, with a big piece of the spike in wage growth related to short-term boosts and one-time bonuses.
Market pros were not expecting a sudden hawkish turn in the Fed’s thinking or its conviction that inflation is transitory, so the move in the “dot plot” with just a few more Fed members expecting a rate hike sooner was enough to take the market by surprise.
A Bank of America fund manager survey ahead of the Fed meeting had found that roughly three-quarters of professional investors agreed with the Fed view that inflation would prove to be transitory.
Into the two-day Fed meeting’s conclusion, some major bond market figures seemed more worried about the Fed messaging coming across as too patient rather than acknowledging risks.
“It’s hard to say it’s [going to be] hawkish because … I think it’s going from uber dovish to overly dovish,” Rick Rieder, Blackrock’s chief investment officer global fixed income, told CNBC ahead of the Fed meeting.
The market was expecting some more dissent among Fed members, and the Fed delivered on that, but still the median expectation for a rate hike is not until at least 2023 and many traders were betting that would remain the Fed’s position. “Some of this hawkish expectation is way overblown,” Michael Arone, State Street’s chief investment strategist for the U.S. SPDR business, told CNBC ahead of the meeting. “Powell is going to say the labor market has 7.5 million jobs to go before it gets back to where it was.”
What the Fed said
The Fed chair said after the meeting in his press conference that what is known as the “dot plot,” which shows when Fed members expect rate hikes, should be taken with a grain of salt — in fact, a “big” one.
“The dots are not a great forecaster of future rate moves … it’s because it’s so highly uncertain. There is no great forecaster — dots to be taken with a big grain of salt,” he said.
Powell added that the current conditions are far from where the economy would need to be in order for the central bank to hike rates. “Lift-off is well into the future,” he said. “We’re very far from maximum employment, for example, it’s a consideration for the future.”
But Powell did speak about inflation in terms that came closer to where the rest of the world’s fears have been residing lately.
“As the reopening continues, shifts in demand can be large and rapid and bottlenecks, hiring difficulties and other constraints could continue to limit how quickly supply can adjust, raising the possibility that inflation could turn out to be higher and more persistent than we expect,” Powell said during the press conference.
Stocks had their worst day since way back in … May — May 18, to be exact. But the 2-year Treasury hit a level it has not seen in a year — June 9, 2020, and the 10-year was yielding 1.575% versus last Friday’s close of 1.455%.
For Colas, what bonds have to say will remain the more important market commentary.
Updated to include Fed meeting results and chairperson Powell commentary.
