Overview of the CPI Report

Today's CPI numbers came in below expectations for both headline CPI and core inflation. The previous figures were 3.7% and 4.1%, while today's were 3.2% and 4% respectively, versus expectations of 3.3% and 4.1%. Not only did inflation fall, but it fell more than anticipated. We had expected inflation to decline, forecasting 3.3% CPI and 4% core, yet we were not surprised to see 3.2% given falling energy prices in September and October. In our view, CPI likely overstated inflation in August and September, so 3.2% seemed reasonable. We have believed inflation would not exceed 4% in 2023, and likely not in early 2024 either. Truflation, a website helping predict inflation trends, states overall US inflation since January 2020 is about 23.5%, providing insight into true inflation.

Impact on Bond Markets:

Both long and short-duration bond yields fell sharply today, continuing a short-term downtrend that began a few weeks ago. This trend followed the Federal Reserve's decision to maintain interest rates at 5.5% and their indication of effective inflation control, negating the need for rate hikes. Concurrently, the Treasury's choice to issue more short-duration T-bills than long-duration Treasuries, as announced in their Quarterly Refunding, also influenced this trend. Additionally, signs of labor market weakness over the last few months suggest the Fed is nearing its targets. While there are optimistic signs in the fight against inflation, it's uncertain if bond yields have peaked. Not only that, but the damage in the real economy might end up being disproportional to the issues inflation has been causing. It’s plausible that the Fed and markets have already sufficiently tightened, but we cannot conclusively say that bond yields won't rise further before reaching a peak, mainly due to the excessive government spending and bond issuance. The current market expectations are that the Fed will cut twice in the first half of 2024, but there is a decent chance this might not happen.

The Falling Dollar:

The U.S. dollar experienced a significant drop today, marking one of its largest single-day movements in 2023. This year, the dollar has remained relatively stable against most currencies, appreciating against some but slightly depreciating against the majority. In the short term, the USD/DXY could bounce in the short-term as it has hit key support levels and showing signs of being significantly oversold. However, it is evident that it is currently in a short to medium-term downtrend, likely to continue its descent.

Stock Market Rally:

Stocks rallied significantly today, rising 2% following the release of the inflation data. We believe the next few days are crucial, as stocks appear to be becoming overvalued. Since their late October bottom, we expected a substantial rally but also anticipated a potential reversal around 4500 due to the nature of their rebound. Current patterns we are seeing in the charts suggest a market top could form 1-2% higher, potentially followed by a new low around 4000.

Economic Implications:

The combination of lower inflation, lower yields, a weaker dollar, and rising stock prices indicate an easing of financial conditions. This ease has been partly driven by the Federal Reserve and Treasury's subtle liquidity management and interest rate adjustments, which have impacted market dynamics. The U.S. government's excessive spending, despite efforts to control inflation, has also influenced the economy. The stock market rally doesn't necessarily reflect the economic state, as factors like speculation, the AI boom, passive investing, and liquidity contribute to stock prices. Notably, only the top 10 U.S. tech stocks have shown significant performance this year, while others have been mostly stagnant. Small caps, down 30% from their all-time highs, suggest that US stocks have been in a severe bear market and a potential recession might be close. Our view had been that if a U.S. recession occurs, it would likely begin in or after Q4 2023, with increasing likelihood over time.

Global Perspective:

Much of the world, especially Europe, is experiencing low growth. Inflation falling rapidly but from higher levels than the US. Negative European inflation in 2024 would be unsurprising given Europe’s much better energy situation, ECB’s balance sheet reduction, demographics, adjustable mortgages, and dramatic rate shifts. China faces potential deflation, thus slowly stimulating economy and markets. Unlike US, China avoided Covid handouts and has taken a very different fiscal and tech sector approach. Chinese stocks have fallen a lot in 2023, but seem to have bottomed even though the Chinese economy might still struggle next year. The US has been better insulated from recession and benefited more from the 2022 USD rise and AI boom. US rate hikes damaged other economies first, helping curb US inflation, but it’s unlikely that this won’t impact the US soon. Geopolitical tensions around Russia-Ukraine and Israel-Palestine also have massive implications on the future of inflation, as they have the potential to significantly affect food and energy markets.

Future Outlook:

Positioning and sentiment have been oddly bullish on stocks, bonds, USD and energy, but typically the market does the opposite of consensus thinking. With the USD and energy falling as stocks and bonds rise substantially, a critical reversal may be close. The market could flush out dollar/energy bulls first, and then stock/bond bulls. As mentioned before, stocks could rise 1-2% more before a 5-12% drop, while the DXY could rise from 104 to 109.5 and yields could spike to 5.5% across 2y to 30y. However, as we expect declining inflation and slowly worsening economic cracks, market could keep rallying further, in anticipation of further stimulus and lower rates. Pre-election, incumbents will likely stimulate the economy while the Fed avoids hiking above 6% and turns more dovish, therefore delaying the recession even further. Although we might start seeing a weakening economy, such high deficits and government spending are preventing the economy from getting into an ugly recession.