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The Fed's Witch Hunt for Inflation

Written by Briton Ryle
Posted May 7, 2018 at 4:08PM

Is today the day? Can we finally get some resolution? I mean, it's been three freaking months, fer cryin’ out loud. I say it's just about time to quit this wallowing around and pick a direction.

The S&P 500 has been weak since the first days of February. Remember that volatility-led sell-off? Yeah, that...

The thing is, I told you this would happen back on February 7:

We will see a retest of the recent lows of the S&P 500 around 2,600. The index will then waffle around that level for a month as prices consolidate and we get more clarity on Fed policy. 

The bottom line is that the environment has indeed changed. I doubt we see any of those relentless grinds higher for at least a few months. Now is the time to get your trading hats on, because we are likely in for some sideways trading with a downward bias over the next few months.

Yep, the S&P 500 has come within 20 points of that magical 2,600 level, like, 14 times since early February. Of all the numbers out there, why did I choose 2,600? It's not some arcane calculation. To paraphrase the mafia accountant in The Dark Knight, I'm not good with calculation. 2,600 is the general area in which the 200-day moving average has been running. 

Markets are funny things. Sometimes they are smart, other times not so much. I would say that momentum (or inertia, if you prefer) is an elemental force, and so it doesn't qualify as a product of decision-making. It's more like momentum either runs out of steam and exhausts itself or gets acted on by some irresistible force. 

So, what does running out of steam look like? Well, go back and reread my opening sentences for this article. That's how a market move loses steam. Traders get so frustrated that they stop trying to take cues from the intra-day action.

The Real Witch Hunt

President Trump has done a lot of griping about witch hunts. (Which hunts? Oh, those hunts.) Seems to me calling a DOJ investigation a "witch hunt" is a classic ad hominem: attack the character and intention of the messenger rather than the actual content of the message. But whether or not it's a witch hunt, I guess we'll know at some point. 

I'm currently far more intrigued by the witch hunt the Fed is on. Because this witch hunt has the potential to do a whole lot more damage than the one in the White House. 

I'm talking about the Fed's maniacal hunt for inflation to justify further rate hikes

Now, Fed Chair Powell hasn't been on the job very long. But I notice a change in tone when he talks about inflation. 

At the end of February, he said: “We've seen some data that in my case will add some confidence to my view that inflation is moving up to target.”

He recently said: “The 2017 shortfall from our 2 percent goal appears to reflect, at least partly, some unusual price declines.”

And he added that inflation readings have gotten closer to 2% over the past several months, “and the 12-month change should move up notably this spring.”

What I want to know is, where's this inflation Powell is talking about?

I find it very difficult to look at this chart and conclude that inflation is breaking out. It looks pretty sideways to me. But Powell still seems to be saying that we get two or three more rate hikes this year as inflation strengthens...

I think we only get one more hike. At least I hope so. Because to me, anything more than one rate hike suggests a serious misunderstanding of the structural aspect of inflation.

It's All About Balance

I'm not telling you there isn't any inflation. There clearly is. Cars go up in price every year. Rents go up. Utility costs, too. My daughter goes to college next year, so I've got a firsthand understanding of college tuition inflation. 

The problem, if it really is one, is that prices might rise in one area, but they are flat or falling in others. The whole internet is deflationary. So is overseas manufacturing. People love to gripe about how globalization has shipped jobs overseas and killed the middle class. But I don't see anyone complaining about $7 t-shirts at Target. If those shirts were made in the USA, they'd be over $20. 

The employment numbers are another area where the inflation witch hunt is going on. Both Powell and his predecessor, Yellen, kept saying that continued low unemployment numbers would push inflation higher. Then you look at the latest unemployment rate — 3.9% — and you say holy crap, inflation must be here!

But that headline number can be misleading. In the wake of the financial crisis, a lot of people could only find part-time work or just dropped out of the workforce. There is a measure for this, called U-6 unemployment. It stands at 7.8%. To me, that says there are still people who can come back into the workforce, get jobs, and have no impact on either the unemployment rate or inflation. 

My point with all of this is that much of the weakness since February has been about interest rates. Traders have been worried about inflation kicking higher and pushing rates up faster than expected. What's more, Fed Chair Powell has helped get traders in this bearish mode with his hunt for inflation. 

But I think it's a witch hunt. And I think the momentum of the inflation witch hunt may have an irresistible force on Friday. Watch for a strong rally.

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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