The bullish argument on Wall Street goes something like this. Home prices are coming down, tech earnings aren’t great, the dollar is coming down, inflation will come down. I agree with some of this because I do think inflation worries can flip into deflation worries next year. Yet, I thought those concerns would hit by September and I was wrong. Humility tells me I can be wrong again, and to be patient even if I’m correct in the end.
Evidence also shows what the market knows (such as inflation won’t be transitory) doesn’t matter for the Federal Reserve. It’s running its own policy based on its internal logic, or lack thereof. Finally, dollar down doesn’t lower inflation. It raises it. The greenback is down 1 percent today and crude is up 3 percent.
I do not know when the current rally will run out of steam, but I still believe it will. Aside from the tea leaves on the charts, I have three pieces of information that make me wonder.
First, as I said above: dollar down, inflation up. Here are two charts showing why I believe this is the default assumption. The first chart is the U.S. Dollar Index futures with crude oil inverted. It shows the two were negatively correlated for most of the past 40 years until the past couple of years.
This is the same chart zoomed in. The historical correlation is back with a vengeance.
Has the market processed this information yet? I don’t see it. I think the market also has taken its eye off the CPI. The Cleveland Fed has hiked its inflation forecast for October.
It also hasn’t processed the final piece in this puzzle. Today, the Canadian central bank surprised with a hike of only 50 basis points. Australia also recently surprised. The market thinks this might be a sign the Federal Reserve will slow hikes or make some dovish remarks because the Anglosphere central banks usually move in the same direction.
Let’s say the market is right. The Fed goes dovish. If trends hold, energy inflation will lift the CPI reading in November on top of the already rising October forecast. The Fed could trap bulls much higher if they spark a melt-up between the November 2 FOMC meeting and the November 10 CPI report. If the report is hot and commodities rally for two more weeks, that seems possible.
The other scenario is the market is wrong. The Federal Reserve is looking at the CPI data, it can see the weaker dollar is a problem for their inflation fight and they don’t care what Canada and Australia are doing with rate policy (which might be done with their housing bubbles in mind). In that case, the rally may only last until around the time of the Fed meeting. A hot CPI report will be the nail in the coffin that sparks selling into December.
My personal view is the rally can end at any moment because it is a technically-driven bear market rally. The above scenarios might not have time to develop if all the moves, in all the markets, are merely technically-driven bear market rallies. If the market has legs though, the combination of higher inflation along with the historic inverse correlation between the dollar and oil returning, and more central banks diverging from U.S. inflation fighting, tells me bulls have run into a field strewn with land mines where a rise or fall in the dollar will quickly become bad news for the U.S. equities markets.