Sell the Good Inflation Rumor, Buy the Bad News

The market can be viewed as illogical quite often when it comes to its reaction to news. For weeks, the experts have been opining that inflation is coming down faster than the Fed thinks, yet stocks have been selling off sharply. Then today the inflation news was worse than expected, implying an even more aggressive Fed rate hiking cycle, yet stocks soared. Experienced investors know the adage, sell the rumor, buy the news. For weeks, our many recent reports have been looking for a market low going into this Consumer Price Index (CPI) report. On the eve of the CPI release we advised buying a panic new low upon the CPI news. Stock indices fell about 4% in the first hour when the 40-year record core CPI report came out and then proceeded to run higher by almost 6% from those lows by the end of the day. A classic sell the rumor buy the news event that managed to cause most to sit on their hands in confusion. There should be more stock buying ahead as many FOMO investors will initially seek any pullback to enter.  An 8 to 10% rally into next week or early November has been our general expectation for this rebound in the stock market.

Our country has experienced double digit deflation in the early 1930’s and double-digit inflation in the late 1970’s. Both periods were very destructive to households and brought our economy to the brink of a financial meltdown. The fear with inflation is that it deeply alters consumer behavior and distorts the mechanisms that determine price, with the risk of embedded inflation leading to violent swings in the economy.  While various inflation measures have been testing 40-year highs most of this year, triggering fear of another 1970’s episode, at least all inflation measures rolled over modestly for the past 6 months. Until today. The core Consumer Price Index (CPI) ticked up to 6.66%, a new 40-year peak. Just when most experts were expecting a continued mild or even sharp decline based upon anecdotal business cost proxies, the Fed now appears vindicated for continuing to tighten credit more rapidly. Some think the Fed is shrinking the money supply and raising borrowing costs to quickly, just as the US is entering a severe recession. Viewing some of the key components of the CPI below, we can see that most categories are not even hinting of rolling over, but instead accelerating. As for recession, increase in travel, the tight labor market and high inflation all argue that we are running too hot. Higher for longer rate hikes should be expected until these trends reverse.

The Fed downplays headline inflation and focuses on the many components of inflation indices. Core index excluding energy and food is key for our central bankers with core Personal Consumption (PCE) being the most important metric for the Fed. Aside from the scary uptrend in most inflation components, analysts failed to properly account for what number was coming off the 12-month average in their estimates. With a very low one month number falling off, it should have been expected that the CPI would rise. With the Fed’s most important core PCE report due October 28th, we feel confident that it will mirror today’s CPI release and show an uptick. We would expect a 5.1% or higher number with no relief in sight for the rest of the year.  Inflation should peak over the next month and then plateau or edge on modestly lower until February. By the end of Q1 2023 we should finally see a more notable correction in the inflation data that will cause the Fed to consider a much slower pace of hikes or even hint at a pause. Until then, traders should expect PPI, CPI and PCE measures to stay too high for the Fed to take its foot off the brake. The next two Fed rate decision meetings are now pricing in 75 point hikes each time, so we will keep our expected rally into November on a short leash.

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