Inflation, interest rates, and market confusion: What’s next?

Outlook

Today we get retail sales and industrial production, with retail sales the focus because the weather in January was simply dreadful and kept folks home, so sales should be lower. We are not so sure, looking at our Amazon bill. In Dec, sales grow 0.4% and the consensus forecast for Jan is -0.1%. Trading economics has zero. If sales are better than expected, not much changes in the fixed income and equity markets. If they fall significantly, it may arouse some anxiety at the Fed. But if sales are strong, as we suspect, it only affirms the current thinking—that inflation is not cooling (and delinquencies will only keep rising).

It's interesting that Trading Economics notes that in Dec, “sales excluding food services, auto dealers, building materials stores and gasoline stations, which are used to calculate GDP, rose 0.7%, the most in three months.” As we just saw with PPI, the market is quick to focus on components to get to the outcome they wish for.

The dollar fell hard against everything yesterday, even the CAD, peso and yuan and not just one or two majors. This could be a repeat of the pullback we had in January that lasted 10 days, but we smell another pullback of at least that dimension, or more.

It’s not logical for the dollar to fall when the US has the better growth, inflation not cooling, a semi-hawkish central banks while everyone else is cutting rates, and that yield differential As noted before, though, sentiment can contain only a whiff of logic. Sentiment can run on other fuel, and it’s doing that now.

Wednesday we had a bad inflation report partly erased by the prospect of peace in two places.  Yesterday we had another bad inflation report partly erased by Trump delaying reciprocal tariffs. The 10-year note fell 8 points on the news. See the one-day chart. This is not supposed to be the outcome after two lousy inflation readings.

Ah, but this time the market was heeding Mr. Powell, who had said key components of PPI feed directly into PCE, and this time most of those components were lower, raising hope that rate cuts are not off the table, after all. Reuters names healthcare (20% of the PCE) and airfares, among other things.

The bond market saw it, then equities, and in short order, the FX market. All the markets also liked some seeming progress on the Ukraine war talks—Ukraine will be allowed to attend. How generous of Trump and Putin. It’s almost certainly going to end up a lousy deal for Ukraine, but no war is better than war in markets.

Can it really be that simple? Well, yes, but there is also an undercurrent of something else in the yield move—stagflation. Everyone knows by now that Trump’s policies are not only bad for inflation, but bad for the economy—even if all we consider is uncertainty alone. We will get a new Atlanta Fed GDPNow today. It may hold a clue to this fate. It was 2.9% last time out (Feb7).

The yield and dollar took a bath on what looks like a delay in tariffs (and progress on Ukraine). This is old-fashioned short-termism. The bigger picture is inflation not cooling down by any measure, whether CPI or PPI.  The PCE may not be too bad when we finally get it because of those special components, but we don’t get PCE until month-end and both the CPI and PPI were bad. There’s plenty of room for inflation fear to return.

See the Reuters chart. Does this look like cooling inflation?

The Fed funds bettors get it—the probability of a single cut at the June meeting has contracted from 45.7% a week ago to 40.3% yesterday but more to the point, the probability of no cut at all at the June meeting is 59.6% (from 66.2% the day before but 35.4% the week before. We are still expecting one rate cut this year, at the Oct or the Dec meetings. Reuters reports futures brought back the target date from Oct to Sept, a subtle and small move. This is going to change, of course.

As for those yields, Bloomberg offers some insight—but not much, and that’s because the bond market itself is confused. “A Bank of America Corp. survey published Friday showed investors have turned less bearish on US bonds, with fewer expecting the 10-year yield to peak above 5% this year, while more see it dipping below 4%. But participants also indicated a sharp decrease in conviction, a reflection of the muddied macro outlook. “These are not easy markets to trade,” said Evelyne Gomez-Liechti, strategist at Mizuho International. She still prefers to sell meaningful rallies in US dollar rates.”

Here’s more: “Nicolas Trindade, senior portfolio manager at AXA Investment Managers, is cautious on US interest-rate risk, or duration, and prefers Europe instead. The firm does not expect the Fed to cut at all this year, in contrast to the 30 basis points or so of easing implied by overnight interest-rate swaps.

‘The main risk for 2025 is a resurgence in inflation that will lead the Fed basically to hike interest rates,’

” he said, adding he loaded up on short-dated TIPs in the days following Trump’s re-election last November. ‘The market is definitely not priced for that.’”

Note that nobody was talking about the term premium or the expected rise in inflation from tariffs and generally chaotic mismanagement in Washington. Again, short-termism and confirmation bias. That doesn’t mean the current interpretation is wrong. It does mean it won’t last.

Forecast

Because it’s Friday, we may expect some retreat from the dollar pullback. But we suspect the die has been cast and the pullback is the real deal.

You never know when a pullback is going to be short, sweet and normal, and when it’s going to repeat and take off like a rocket for a second time. We have been searching for literally decades for a formula to identify false vs real pullbacks. Some fall back on cycles (good luck with that) and some with Fibonacci, but you can always find a Fib retracement if you change the span or the time frame to fit. 

Right now the Fib retracements of the move from the Aug 22 high to the Jan 10 low lie at 1.0573 for the 38% and 1.0696 for the 50%. Both the Schaff indicator and momentum show that this time, the move has room to run.

We don’t like it because it defies logic and basic economics, but there it is.

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