Inflation Punch
Just when the market started to price in a possible peak, the May ‘22 inflation data delivered an unexpected punch. The monthly price increase topped 8.6% in May, up from 8.3% in April. The NASDAQ dropped 3.5% in one day follow by the S&P at 2.9%. The 10-year treasury yield shot up to 3.156%. At the start of the week it stood below 3%.
Inflation, for the sake of market stability and recovery, is clearly going in the wrong direction. May’s numbers likely reflect services inflation becoming the new lead indicator ahead of core goods pricing which owned the headlines for the last couple quarters. The war in Ukraine rages on in a new phase of entrenchment, contributing to ongoing rises in energy and food prices. With the EU likely cutting back on Russian oil exposure in the near future, the energy price situation is only likely to grow worse. Finally, the psychological component appears to be ramping up as well, becoming part of the main street narrative. One doesn’t need to look far beyond the gas pumps, food prices and layoff announcements to see how consumers and business owners are coping with the future unknowns. What do people do in times of fear? Retrench on discretionary spending, liquidate into cash, defer investments, and hold on tight until positive signs once again emerge.
The bigger implication of today’s reading really lies with the Fed. Inflation must killed. It’s their sole mandate at this point. Consumer spending pain must be addressed and the Fed’s credibility must be regained after the blown “transitory” call earlier this year. The June ‘22 and July ‘22 meetings will inevitably see 50 bps rate hikes. The same might be on the table for Sept and the Oct meetings. The Fed has no choice but to choke the death out of demand, and likely take the economy down with it. Ironically, the very low-income consumers they hope to help must be deterred from certain consumer markets, like gas consumption, before inflation will subside. To top it off, the level of planned QT is unprecedented compared to the last decade. Forecast show rate hikes at 2x the levels of previous Fed tightening episodes. We know how those all ended… Further, they plan to withdraw nearly $1T of liquidity from global market by year-end, nearly three times as fast as previous tightening episodes.
Whereas easing and intervention were options for the Fed previously when markets were falling like they are doing now, the inflation dilemma has now tied their hands. The tightening show must go on no matter the level of asset valuation destruction that occurs. This difference between now and then can’t be over-stated enough. How this plays out will be my sole focus for the rest of 2022.