Long time deflationist David Rosenberg is beginning to worry about inflation more and more. He doesn’t think a 4% yield on the treasury would be surprising, but he also believes the inflation problems are going to begin posing real problems for some of the key drivers of the equity markets such as the future of QE and low interest rates. From this morning’s note:
“There have only been a handful of times in the past when both food and energy prices were rising so sharply in tandem. Since almost 25% of the CPI basket is in food and energy directly, and this does not include the areas of “core” that are sensitive to these commodities, such as transportation costs, it would seem There have only been a handful of times in the past when both food and energy prices were rising so sharply in tandem. Since almost 25% of the CPI basket is in food and energy directly, and this does not include the areas of “core” that are sensitive to these commodities, such as transportation costs, it would seem logical to assume that we are going to get some headline inflation in coming months. If you recall, the headline inflation rate was 1.4% in October 2006, only to then jump to 5.5% by July 2008 — and then to zero by the end of 2008. Where is the inflation rate now? At 1.5%. It was 1% last June so the uptrend is starting. Also consider that we could get a few months of +0.3% prints in the core CPI too, especially as the surge in cotton prices kicks into apparel, and the last time we had a string of these — November 2007 through to July 2008 when we had four of them — the equity market took it pretty hard (bonds had already priced it in, as they are doing now). It’s been well over two years since the markets had to contend with just one monthly 0.3% print on the core CPI so it goes without saying that after such a long hiatus that a few of these would take investors by surprise after being conditioned to numbers that have been around +0.1% now for so long. Those days are over, but only for now, and the bond market is busy discounting this while the stock market is not focused just yet on the implications, which could be very important since even a mild uptrend in the core inflation rate would very likely stop QE3 right in its tracks … leaving equities without the spark that ignited the rally last August.
It’s not just 4% on the 10-year yield that matters but as the FT pointed out last week in the Short View column, whenever the inflation rate pops its head above the 4% mark and stays there for at least three months, we ran into a serious stumbling block, as far as the stock market goes, a good part of the time (stock market suffered losses 70% of the time). We went back into the history books and found 13 occasions when this occurred over the past nine decades. Over the next 3, 6 and 12 months, the average move in the S&P 500 was -5.4%, -9.4%, and -10.6%, respectively. The median moves were -5.3%, -9.2% and -13.3%.
As far as bonds are concerned, the average move in the next three months after seeing inflation first hit 4% was +1bps; over the next six months the average yield move was +9bps; and in a year -13bps. The median was -11bps, -12bps, and -33bps (this sample went back nearly 60 years). So it is interesting to see that after we hit the 4% threshold on the inflation rate, bond yields are stable to lower in the ensuing months; the earlier run-ups in yield are what leads to the undoing of the equity market. In other words, the bond market braces itself for the inflation bulge ahead of time whereas the stock market ends up reacting to it once it has already arrived — by which time the bond market is treating the inflation jump as old news. After all, inflation is a lagging indicator. And when you read the big bold headline of How to Profit From Inflation on page B7 of the weekend WSJ (we are talking about a whole section here!) then you know that the Treasury market has already discounted a lot of this; though the stock market is seemingly oblivious — but just for now. “
Source: Gluskin Sheff