Picture a rubber band, stretched to its limits. Picture a razor blade gliding across the rubber band.
The rubber band is the U.S. stock market. The razor blade is rising short-term interest rates. And even if you don't like the analogy, know that this is the thing that Wall Street fears more than anything.
How many times in the last year have we heard that the only thing that could kill this bull was the
? That it did not matter that valuations were all stretched to hell so long as inflation didn't rear its ugly head.
It didn't look like that was going to happen -- heady growth and low employment had been harbingers of the hoary beast in the past, but now it looked like inflation had left the scene. Some proclaimed a new era, derided Phillips-curvers (our friend in Drinking Hole, Wyo., had
things to say about this notion) and spoke of how gains in technology had created such gains in productivity that the U.S. would be able to grow at a blistering pace without consequence.
Even the Fed conceded that there was something different about the economy. Unlike 1994, where it struck pre-emptive blows against inflation when the early warning signals sounded, the Fed indicated that it wouldn't move until it could actually see the damned thing.
But lately there have been signs that the U.S. has been getting a little too heated, and that inflation may be nosing its way into the economy. Friday's release of the April
Consumer Price Index
-- the key read on inflation -- appeared to confirm these fears. It was much stronger than economists had expected, with an increase of 0.4% in the core rate vs. an expected 0.2%. Before the report came out, only alarmists were convinced that the
Federal Open Market Committee
would move to a tightening bias -- the prelude to a rate hike -- at its meeting on Tuesday. After the report, that view got a lot more prevalent.
"The figures that came out, they shocked the Street," said Stanley Nabi, chief investment officer at
DLJ Investment Management
. "There was a great deal of complacency. Very few people thought there was any inflation in the system."
At its December meeting, the FOMC decided that it would, if it wishes, announce a change in bias at the end of a meeting. Previously, the market found out about bias changes either in the minutes (put out a couple days after the next meeting) or through a couple of members of the press through whom the Fed let its will be known to the market.
As a result, tensions will be extremely high ahead of the meeting. Volumes in the first part of the week will be on the low side, and except for a few cowboys in there betting that there won't be a bias change, and that as a result stocks will rally, interest will likely be sporadic.
The cowboys may well have it right. The bond market appears to have already gone a long way toward pricing in a change of bias, and bonds could rally if there's no announced change.
"I'm constructive on the bond market, because I don't think a 0.4% increase in the core CPI is the end of the world," said Richard Gilhooly, senior bond strategist at
Paribas Capital Markets
. "I personally do not think they're going to move to a tightening bias, in which case you're going to have a relief rally Tuesday afternoon and Wednesday."
Yet even that one- or two-day rally would be hard pressed to reverse the bear market in bonds. At the end of last year, economists were talking about how many more times the Fed was going to ease. In winter, they were talking about how the Fed wasn't going to move "as far as the eye can see." And now? Now you hear things like this:
"We're forecasting a tightening," said Suzanne Rizzo, U.S. economist at
. "We don't think the economy is going to slow unless the Fed takes back the easing they did last year and then some."
While they might not see it next week, that would certainly mean more trouble for Treasuries. And with the yield on the 30-year pushing 6%, trouble for stocks as well.
"You need monstrous growth to justify where the market is trading right now," said Doug Cliggott, equity strategist at
. Cliggott is beginning to think the market may be in for a nasty fall. Looking at the last five times the market has seen powerful rotations out of growth and into value, the
has seen a serious drop within the following three months. It does not help matters that Cliggott's model shows stocks more than 30% overvalued.
Cliggott is not alone in his views that the market could get violent. For investors who keep their powder dry, this may not be a bad thing. "I will tell you right now I don't see a traditional bear market staring us in the face now," said Nabi. "I think that between now and midsummer we are very likely to have a sizable correction. A sizable correction and then a bull market."