Inflation is tame or tamer as expected

Outlook:

We get US CPI at 8:30 am today, expected at 1.6-1.7% y/y. Market News has 1.7% but Bloomberg has 1.6%. Bloomberg notes that the spread between regular 10-years and 10-year TIPS is 1.91%, down from 2.31% in Jan, and signifying falling inflation expectations. But just as Fed funds futures are a lousy indicator of actual Fed funds rates as the maturities appear in real time, we have no evidence that TIPS is an accurate forecaster of actual inflation.

The only thing that counts is whether the FOMC voting members believe a falling TIPS will influence behavior in a feedback loop. It may influence financial professionals but since 99.9% of all consumers never heard of TIPS, it’s not clear the Fed should take any action, ever, based on TIPS or the TIPS spread. Of course inflation expectations are falling—you can’t turn on the TV without hearing that gaso-line prices will fall any day now (we’re still waiting). So far we have no proof that expectations of fall-ing inflation are causing businesses or households to defer investment or consumption.

While CPI today is really not an important event, many market players are going to act as though it is. In particular, equities can be expected to rally some more if the number is on the low side, on the grounds that low CPI will make the Fed more dovish. This is almost certainly not true. What would make the Fed more dovish is not inflation per se, but rather unemployment rising again and specifically wage gains falling again. The Fed has given us plenty of evidence that it’s employment that counts, not inflation. It’s a factor, but not the main factor. We would have to see something scary, like 1%, for the Fed to re-act, rhetorically if not in real actions. Remember that in Europe, inflation is at 0.3% and some countries (Italy) have outright deflation.

So, assuming inflation is tame or tamer as expected, look for a stock market rally. Yesterday delivered the biggest one-day gain in the S&P in a year, what the FT calls “a stunning turnround for the world’s most closely watched equity gauge. Just a week ago the S&P 500 hit 1,821, a six-month low that left the US stock market almost 10 per cent off its intraday record set in September.” It’s not the level that counts, it’s the volatility. Is stock market volatility in any way a signal of “instability” and something the Fed should respond to? Probably not. Everyone knows equity markets are irrational.

Besides, it’s not US conditions that count today in terms of evaluating the FX benchmark, the euro. First comes the ECB keeping secrets and not being transparent, sneaking around buying bonds and letting the market figure it out. The normal course of action is to announce, get an effect, do it, and get another effect. Draghi is among the most famous announcers of all time (“Whatever it takes”). Stealth inter-vention is a change in style, and that’s really very interesting. What is he up to? Maybe he is just side-stepping the BBK, but we’d guess there’s more to it than that. The silence from the Bundesbank is positively deafening.

Then there is the bank reviews due on Sunday. If the Spanish news service is right, 11 banks will fail and be forced into raising new capital (or worse). This information was probably leaked to get us ready and is not actually much of a surprise—it’s fewer than 10% of the banks under review (some reports say 128 banks and some say 130 banks). After all, for the ECB to say all the banks passed with flying colors would not be credible. Some have to fail in order for the ECB’s new regulator status to have teeth and claws.

A few deductions: some bank stocks have already responded, like the ill-fated Monte dei Paschi in Italy (down 10%). Others are sure to come. The question is whether entire bourses get contaminated by the banks. At a guess, no. Secondly, will the failed banks be able to raise new capital easily? If not, techni-cally the cure is a hit on the bondholders or even depositors—shades of Cyprus—or member govern-ments, who may then have to draw on the European Stability Mechanism. Spain and France are the two members most in question, although you must admit it would be fun if a German banks fails. The Ger-man banking sector is notoriously inefficient if not downright incompetent, so that is not a remote possi-bility.

Europe has enough troubles of its own in both the economic and institutional conditions that you would imagine a falling euro whatever the US data. The logic of these fundamentals is impeccable. And yet we always worry when the dollar is rising—it’s inherently vulnerable.