Talk Is Cheap

Now that the CPI data has confirmed the widely telegraphed investor consensus of peak inflation, it's time to look past all the cheap talk. Last month the market grasped the first straw of lower-than-anticipated inflation and pushed the risk markets back into full gear. All it took was a pessimistic, cashed-up market to accept the end of tight money was in sight, and off to the races we went. Is that all we needed for markets to announce the end of the bear market - cheap talk? And widespread talk of a recession that now looks less likely has set markets up for today's upward chase. But that's what markets do - they make the most people wrong.

How do we process the bullish tilt to the last four weeks, given that it is premised on a pollyanna scenario unsupported by such little evidence? Yes, inflation has peaked, especially in hard goods such as oil and lumber, but where is the evidence of services inflation deceleration? The tight labour market is still tight and the cost-push inflation stemming from that phenomenon has yet to show any response to the rise in administered rates generated by our hapless monetary authorities. Sticky sources of inflation - unit labour costs and rents - are still stubbornly high. and show no signs of coming down soon.

We tend to forget the recent track record of forecasts at our peril. This time just one year ago the consensus was that a 50 basis point hike in Fed funds was all that was necessary to quell the nascent inflation that was widely dismissed as transitory. If you predicated your strategy for 2022 on that fantasy, how's that working out for you? But that was the accepted narrative back then, despite the building evidence to the contrary.

Tomorrow, Chair Powell will talk and the markets will pass judgment on those words. Most likely there will be much forensic scrutiny of any verbiage he may provide that could be seen as confirmation of the peak inflation narrative. But the markets have already moved on from that backward-looking view. The rally is on again, based on a Fed pivot scenario that is playing out as we speak.

The accepted wisdom has been centered on a recession in the first half of next year. As a result, market futures had been pricing a terminal rate that is fully 200 basis points below current short-term yields. And that's before tomorrow's 50 basis point hike. But if the consumer is still able to readily get a job, and those jobs are paying more, where is the recession going to come from? With the recent early Christmas present of lower oil prices, combined with an explosion of real wages, I don't see that recession forecast anywhere in sight. If anything, there is a good chance that the economy continues to surprise on the upside, landing softly as it does.

Is that what a 10-year yield below 3.5% is saying? I don't know, but I do know the Fed can't be comfortable with the current rally in both riskless and risk assets so soon after the reversal of inflation's second derivative. They are likely to push back against the calls of "mission accomplished". But their words will be ignored by the momentum-chasing bulls who have now wrested control of markets. Like a financial D-Day, the 'soft landing' assault on the bears has begun.

And only a 'soft landing' narrative squares the circle of the current variables. In that scenario, the Fed will pull back from rate hikes by mid-year, letting the deceleration of inflation work through the system. And while that is supportive of risk assets from a valuation standpoint, the offset is a higher cost structure that squeezes profits just as corporate pricing power erodes. But the lags in that sequence give us enough runway to extend the rally for now.

Unfortunately for this bullish argument, a soft landing will also renew the challenges faced by the bond bulls who are chasing yields lower on the inflation peak data. Anything less than a full-on recession risks fomenting a renewed second-half inflation surge. Such a rebound is not in any scenario I have yet seen promoted rcently. Inflation expectations are sequentially lower, judging by the forward market's pricing of the yield curve. But those thoughts are for another day. With inflation expectations dwindling - driving yields lower, and with a still strong labour market, investors can have their cake and can eat it too for now. Any talk of a recession is just that.

Is it a new bull market? Hardly. For that, we need a Fed that can ease after a true recession. A soft landing now forstalls that until at least 2024. Just a Fed Chair of the past, Paul Volker discovered in 1981, inflation is harder to stamp out than you think. But for now, the bear market rally is still on, courtesy of cheaper money.

But enough cheap talk now, I've got a short to cover.

Risk Model: 4/5 - Risk On

The Model has had it right all along. Lower Implied Volatility, improved Sentiment, and rising Copper/Gold are all signaling a soft landing for both the economy and for risk assets. The Model has laid down the law - and the law won. Damn black box! The most anticipated recession in history may not be all that bad and that is actually bullish for equities in the short run given a sharply dropping yield structure. We have been lulled into a bearishly tilted complacency. The year-end race to re-risk is back on.

As for Copper/Gold, many have put the China re-opening scenario at the top of the list as critical in informing their view. What if the U.S. soft landing scenario is actually at work here as well? In any event, I don't dismiss the chart below as it has been consistently right this year. A repeat of the 2020 'V-shaped' rebound for the economy has been underway since the second quarter weakness. But there is also some formidable overhead resistance to overcome at some point. A slight global growth rebound, aided by a weaker dollar and lower energy costs cannot be dismissed as a viable scenario for now. Dr. Copper says so. And when he talks, I listen.

Copper/Gold