Back to top

Image: Bigstock

Inflation Perfect Storm: The Fed's Dual Conundrum

Read MoreHide Full Article

  • (1:30) - Centrifugal Force: Markets Coil Then Jump
  • (9:20) - Big Move In Bonds: Financial Plumbing Pressures
  • (15:10) - Richly-Valued Growth Stocks Overdue to Correct
  • (20:40) - GameStop Stock Surges Again: How a Pro Traded It
  • (24:15) - Stimulus + Growth + Inflation = Commodity Prices Rising
  • (29:00) - Technical Targets for the Nasdaq 100
  • (37:00) - Good Lessons For New Investors are Everywhere
  •  Mind Over Money Archive


Whether or not the stock market just peaked for the near-term of the next few months, one market move is very clear: interest rates and inflation are sharply on the rise.

Before the Nasdaq took a nearly 6% dive this week, the yield on the 10-year Treasury note had been surging. From the start of the year through Monday, that benchmark interest rate moved 50% higher from just 91 basis points to 137 bps.

The message was also pretty clear: even if the Federal Reserve was committed to keeping short-term interest rates low to restore employment, market inflation fighters that we used to call the "bond vigilantes" were going to start getting realistic about all the cheap dollar liquidity and fiscal stimulus sloshing around and driving up asset prices in stocks, commodities, and bitcoin.

And as the 10-year yield spiked above 1.5% this week, the selling in stocks accelerated. Now a 1.5% long-term interest rate doesn't sound alarming all by itself. But some pressures of financial plumbing apparently need adjustment when the rate jumps that quickly.

Since the dividend yield on the S&P 500 is also about 1.5%, risk-free Treasuries now offer a credible alternative for large asset managers to richly-valued stocks.

To get a handle on the inflation that the bond vigilantes are seeing, I invited Jeremy Mullin on the Mind Over Money podcast. Jeremy is professional day trader who also runs the Commodity Innovators service for Zacks.

He describes where inflation was showing up in commodity markets from grains and meat to oil and gold even before the big bond move. Be sure to listen as we also discuss the next move for growth stocks in an overheated market.

Growth Stocks Lead the Way

Don't get me wrong. We're still in a great bull market and the bond market forecasting higher inflation is a confirming signal that stronger economic growth is on the horizon. There's certainly enough stimulus sloshing around to make it so.

And in that sense, the Fed is winning the war on the dreaded scourge of deflation that Japan has never been able to recover from. But now I believe they might be trapped "behind the curve" as they let core inflation measures like CPI and CPE run very hot until they get employment robust again following the pandemic shutdowns.

In short, the Fed's dual mandate -- full employment and stable prices -- may be turning into a "dual conundrum."

Still, even if stock indexes enter a double-digit correction, I'll be buying with both hands. But the thing to keep in mind is that growth stocks are always the advance guard and they lead the way. We just saw technology and software stocks -- as the leading forces of deflation -- soar in the past year, and now they are due for some give back.

For my part, I started getting cautious in early January when I did this vlog: Technical Forecast: Frothy With a Chance of Complacency

I had been trimming my growth stocks and raising cash. And I held on to pieces of great companies like NVIDIA (NVDA - Free Report) and watched them all peak in the last week or so.

Getting Star-Struck By Growth Stocks in the Clouds

I admit, I was a little star-struck myself, caught up in the same euphoria as everyone else. So I didn't time the exits very well when I knew better and felt in my gut I should have been selling into the last frothy push on Monday with Square (SQ - Free Report) above $270, Baidu (BIDU - Free Report) above $340, and Shopify (SHOP - Free Report) still near $1,400.

Growth stocks could still make another run to the peak at Nasdaq 13,800 or at least a shot to close the Monday gap up to 13,500. And in the meanwhile, I'll be going over the whole picture in more detail to see if some bigger shift is occurring that I don't want to be on the wrong side of.

As I was prepping for my podcast with Jeremy on inflation, one piece of data hit me like a hammer: the Wilshire 5,000 (really only about 3,500 stocks now) had hit $42 trillion in total US market capitalization this month.

Why is that important? Well, it's about 200% of GDP for starters.

You may recall I addressed this in August when the Wilshire was "only" $34T and 177% of GDP. You should read this article again, and watch the video too to see all the charts, including the Fed balance sheet and the rapidly growing US deficit...

Inflation Coming? 12 Charts You Must See to Believe

Before I dive into the complex plumbing of financial markets in unprecedented times of central bank QE (quantitative easing), below are some key bullets that frame the discussion. Because the dynamics of these forces can get really complex, really quick. And I'm not saying we need an economist to figure it out for us, because we don't.

Markets are the most complex, multidimensional systems on the planet and when you have huge, forceful players like central banks, the financial plumbing and pressures get hard to sort out.

So here are 7 dynamics I'll be talking about that all interact in a constant feedback loop of liquidity drivers and pressures...

1. Technology Innovation & Deflation: gigantic historical trend, more powerful than any gov or central bank
2. Fed Deflation Warfare: artificial suppression of interest rates plus QE bond buying to flood the world
3. Global FX Rate Parity: money seeks yield and drives carry trades to borrow cheap and speculate
4. Pandemic Shutdown: Fed was ZIRP fanatic before; convinced Congress and Treasury to go all-in with stimulus
5. Fed Trapped: now they have a "dual conundrum" of broken employment and high inflation
6. Perfect Storm: bond vigilantes finally get leverage to price in big growth, big deficits, big inflation
7. Centrifugal Force: market relationships can go extreme and coil for a long time... and than unwind fast!

My top dynamic was and remains Technology Innovation as the driving force of economics that delivers exponential efficiency of production and marketing to every industry.

One theme I left out is my oldest truism of markets: "They have to buy and they don't have to sell." I'm talking of course about large asset managers with big cash always entering their coffers from the investment machinery of capital markets. You can learn more about one such giant of long-term thinking in my vlog Scottish Warlords of Investing: Baillie Gifford Sells TSLA, Buys TTD, Holds SHOP.

Indistinguishable From Magic

Ironically, one of the central forces of deflation for decades has been semiconductor chips that just keep getting smaller, more powerful and cheaper. And now there is a chip shortage, sending those stocks, like NVIDIA (NVDA - Free Report) to all-time highs.

It was nearly 60 years ago when Arthur C. Clarke said this in his book Profiles of the Future: An Inquiry into the Limits of the Possible: "Any sufficiently advanced technology is indistinguishable from magic."

How true it has become, beyond even his dreams, when a child can hold the power of thousands of computers in the palm of her hand.

But technology innovation also disrupts industries, and eliminates many jobs even as it creates new types of work. This is the unstoppable force that the Fed is pushing against with ultra-easy monetary policies to foster investment that will get people back to work.

And the pandemic just made their goal an order of magnitude harder as we witnessed 10 years of advanced technology adoption in just 10 months. From the work-at-home demands on completely digital, cloud-based systems and commerce to factories reaching deep for automation and robotics solutions in a socially-distanced world, the world of work has been turned upside down.

Companies like Square (SQ - Free Report) , Tesla (TSLA - Free Report) , and Baidu (BIDU - Free Report) are leading the charge of "disruptive innovation," as Cathie Wood of ARK Invest has explained so eloquently and forcefully for the past few years.

My list of 7 dynamics is by no means complete or perfect. While the big idea is how Technology Innovation rules, the underlying theme is that markets are very complex, but not always very efficient because of human emotions and behavior, which swing back and forth like pendulums.

Centrifugal Forces: Coiling, Tightening, Exploding

Here's the 5-minute intro monologue for my podcast with Jeremy if you want to read it first. But be sure to listen to our full chat as he tells why he sold Bitcoin above $57,000 when he saw the euphoria getting crazy.

When I was a currency trader in a former life, I struggled to understand how to catch the really big moves in the Japanese yen, the Australian dollar, and the new euro currency that had just launched.

Even if you were using lots of fundamental analysis in combination with technical charting tools, jumping on too many false breakouts that confirmed the bottom in the euro at 80-cents was a recipe for ruin.

And this was before I started really diving into the mass psychology of markets with the help of Benoit Mandelbrot's ideas of "wild randomness" and Nassim Taleb's concept of The Black Swan.

Twenty years ago, I was still just focused on individual psychology, that your own mind was the obstacle you had to overcome to trade well. So I relegated the "big moves" in currencies, commodities, gold, and stocks to what I called "centrifugal force."

The price of an asset would coil and twist for years sometimes before it suddenly snapped like a spring, loaded with pent up energy. Markets could remain inefficient for a long time, until they quickly jump to a new equilibrium level.

In short, I stopped trying to predict when a breakout was going to occur and simply jumped on board the move once it was in full motion.

The Bond Bubble Was Engineered to Break All Bond Bears (and now it can pop)

Well, imagine being a bond trader and inflation hawk in the past few years, waiting for that day when excessively easy Federal Reserve monetary policies would finally ignite inflation and bond holders would rush for the exits. That's been a losing trade for a decade.

And listen, I've been following this kind of logic for a long time, back to when everyone was worried the Chinese would sell all their US Treasuries and move into the euro. The wails of panic about the US dollar losing global reserve currency status, and essentially imploding, were deafening.

But it didn't happen because the US-China trade deficit that fed their Treasury appetite was a big long-term trend, driven in part by a fixed currency peg for the Chinese yuan. Besides, for the US dollar to implode, the euro currency would have to soar.

We saw some of that in 2008 as the dollar fell in relation to both oil and the euro, which surged above $140 per barrel and to $1.60, respectively. But over the long-run, for the #1 and #2 economies in the world, it will simply go back and forth. As I learned long ago, in FX "it's all relative."

The other thing I learned is that your currency's direction is determined by the direction of your interest rates. Rising rate currencies get bought, and falling rate currencies get sold. In fact, it's a type of borrowing of the cheap currency to buy the more expensive one, relatively speaking.

The funding currency creates a carry trade for borrowing and buying all kinds of assets, from gold to stocks.

And because of the Fed's decade-long commitment to keeping interest rates low, the US dollar has been a terrific way to borrow and buy every asset imaginable, including Bitcoin.

Plus, QE bond buying got a big shot in the arm last year when the Fed decided to buy corporate bonds to support the economy and the stock market.

Last summer, I did a vlog titled Inflation Coming? 12 Charts You Must See to Believe and one of them was a view of the value of the US stock market vs GDP at 177%. Yep, the market cap of the Wilshire 5,000 was $34 trillion vs. GDP slipping under $20T.

Since then, the Wilshire 5000 went to $42T this month!

Meanwhile, the coronavirus pandemic ignited massive Federal stimulus payments to offset the surge in unemployment and shut-down businesses like restaurants. I'm still hearing stories about folks who got forgivable loans of up to $10,000 by pretending they had a legitimate business that was derailed by the pandemic.

Lots of that money went into stocks and other assets.

Preparing for Inflation We Haven't Seen in Decades

So I am exploring the possibility that we could be headed into a perfect storm for inflation when the world is flooded in cheap dollar loans that soon need to be repaid.

When a global carry trade in FX needs to unwind, it can create a good amount of volatility for a few weeks. When the biggest carry trade of all time needs to unwind -- fueled by a $7+ trillion Fed balance sheet and a $4+ trillion government deficit -- it could be very volatile for a while as all the one-way short dollar trades reverse.

Why? Because the Federal Reserve continues to be super transparent about their commitment to not only stoke inflation, but also to let it run hot as they focus on a longer-term average.

That means they could be willing to let inflation measures go to 3% or above to make up for all the years we were at 1% or below.

I think the Fed is now trapped in a "dual conundrum" where their commitment to restore employment after the pandemic shutdown means they are "hands off the wheel" on inflation.

That means the bond vigilantes are in charge and could create a lot of volatility for stocks this year.

And that means there will be lots of opportunities to buy your favorite technology and software stocks at more reasonable valuations.

Disclosure: I own shares of NVDA, SQ, BIDU, and TTD for the Zacks TAZR Trader portfolio.

Published in