The latest CPI numbers were released on May 12, showing a 0.8% increase in prices from the previous month. This number was well above the 0.2% that was expected, and it triggered a quick 2.5% loss in the S&P 500 and an even greater loss in the Nasdaq. Is the market terrified at the prospect of coming inflation? I believe the answer to that question is complicated.
'Transitory' or Here to Stay?
When we see lumber prices up 500% from their early pandemic lows, and many other commodities that are following suit, it’s tough to argue that inflation isn’t already here. Even Federal Reserve Chairman Jay Powell has acknowledged the existence of inflation, but he’s also dismissed it as being “transitory.”
Inflation can be caused by several different factors. Supply disruptions, labor shortages, volatile demand spikes, or waning currency confidence all cause different types of inflation. If Powell believed that supply disruptions were the primary driver of higher prices, then it would make sense that the inflation was transitory. However, if there was reason to believe that a spike in demand was sustainable or that people were bracing for a declining dollar, the inflation we currently see could cause more long-term concern. With the national debt has increased by $6 trillion since the onset of the pandemic and M2 money supply exploding to near $20 trillion, those currency concerns seem appropriate.
Traditional Indicators of Inflation Fears
Historically, the market has relied on the value of the dollar and the shape of the yield curve for insight into the market’s inflation fears. Unfortunately, both of those measures are currently experiencing difficulties with their normal predictive efficacy.
The dollar index as our standard measure of currency strength could be causing more confusion than clarity. Over 70% of the composition of the index is the yen and the euro. In the current global economic crisis, the Bank of Japan and the ECB have engaged in similar currency weakening strategies in the name of stimulus, as the U.S. has. An argument can be made that the index has been rendered worthless as all three currencies decline in unison.
The other traditional indicator of inflation fears is the shape of the U.S. yield curve. We would expect longer-end interest rates to spike higher if inflation were a market threat. Unfortunately, there are some problems with this measure as well. The Federal Reserve continues to buy $80 billion per month of longer-end treasuries (and $40 billion of mortgage-backed) in a direct attempt to keep long-end rates low. Manually controlling long-end rates obviously calls into question the resulting rates message.
The market has been forced to look to non-traditional assets for signs of inflation. Cryptocurrencies have given us some clues as the cryptocurrency market cap has gone from $150 billion 14 months ago to around $2 trillion today. Cryptocurrencies are not susceptible to supply disruptions, so it seems reasonable to conclude that some of their meteoric rise is due to currency concerns. It’s also possible that cryptocurrencies are responding to the excitement over new technology or the fear of missing out, but when viewed alongside other commodities and risk assets, a reasonable conclusion is that the market is not convinced that the inflation we see is transitory.
Risk Assets’ Reaction
But why did the market react so poorly to the spike in the latest CPI data? Because it’s not the inflation that upsets risk assets. Risk assets like inflation, particularly when they are the actual assets that are being inflated. What risk assets don’t like is the belief that the Federal Reserve may have to step off the sidelines and address inflation. A high CPI number is very visible and very public and perhaps cannot be ignored. The next couple of months should be fascinating as we see how the inflation discussion progresses.