The January inflation numbers came in a little higher this morning.

Stocks were crushed.  Yields spiked.  And the dollar rallied.

How bad were the numbers?  Core inflation (excluding food and energy) was less than a tenth of a percent above expectations.  The 12-month change was 3.88%.  That’s the lowest level of this inflation cycle, and it was the tenth consecutive lower year-over-year core inflation reading.  Doesn’t sound so bad. 

What about the headline number?  It was also a tenth of a percent above expectations on the monthly reading.  The 12-month change fell from 3.35% to 3.09%.  It didn’t crack 3%, but it was the lowest reading of the past seven months. 

Clearly this wasn’t the positive surprise we thought we might get today, but did it warrant a 4% selloff in small cap stocks, and a 14 basis point rise in the 10-year yield?

Let’s take a look at the two other times in the past three years that shared the features of 1) a down greater than 4% Russell 2000 and 2) at least a 14 basis point spike in the 10 year yield. 

It happened on February 25, 2021. 

What was going on?

It was about inflation.  The 10-year yield had risen from 1% to 1.6% in less than a month.  And the move was quickening.  And this quickening was driven by the market’s judgement that the additional $2 trillion fiscal package coming down the pike from the new President and his aligned Congress was inflationary at best, and recklessly extravagant, at worst.

The $2.2 trillion Cares Act and the additional $900 billion in stimulus passed in December, before Trump’s exit, had already driven a nearly full V-shaped economic recovery (by late January ’21).  And the economy was projected by the CBO (Congressional Budget Office) to grow at a 3.7% annualized rate in 2021 (hotter than pre-pandemic growth), with an unemployment rate falling to 5.3% – about right at the average unemployment rate of the past 50 years.  

The prospects of more, massive spending packages looked like an inflation bomb.  

This feature of a big 4%+ down day in small caps and spike in yields also happened on June 13 of 2022. 

What was going on?

It was a Monday meltdown, following a hot Friday inflation report. 

The Fed had just started tightening and was way behind the curve. 

Inflation was near 9%, the Fed Funds rate was below 1%.  With a Fed meeting just days away, the market ratcheted up expectations for an aggressive 75 basis point hike.  And history suggested they needed to take rates a lot higher in order to stop fueling inflation, and start curbing it.

So, in both cases (Feb of 2021 and June of 2022) stocks fell sharply and yields spiked on significant inflation fears.

It’s fair to say the circumstances are quite different today.  The Fed trajectory of inflation continues to go the right direction (lower).  The Fed is clearly looking in the direction of cutting rates, not raising rates. 

With that in mind, was the selloff in stocks (and bonds) today an overreaction?  It looks that way.

Let’s take a look at the Nasdaq chart, which incorporates the dominant tech companies that are leading the next industrial revolution.  It trades perfectly into this big technical line of support — the trendline from the October lows. 

The S&P futures traded into a similar line today. 

And this trendline has significance.  The October lows were driven by 1) Jerome Powell’s intimation that the market had done the Fed’s job of tightening, 2) the major reversal signal (outside day) that followed, in the bond market … and 3) the huge Q3 earnings from the big tech oligarchy, and the reveal that they were all reorienting their businesses around generative AI. 

The Nasdaq is on new record highs, led by the dominant tech stocks that are building and delivering the first waves of generative AI.

Meanwhile, the Russell 2000 (small caps) is down on the year, though less so after today.  The nearly 9% divergence started to slowly close today.  The Russell 2000 was up 1.7% on the day.  Nasdaq was relatively flat.

The performance divergence isn’t just small cap related, it’s broad-based, as it was for much of last year.  If we look at the equal-weighted S&P 500, it’s up just half a percent on the year.

But remember, the performance divergence between “big tech and the rest” narrowed aggressively over the final two months of 2023.  And it was triggered by Jerome Powell’s signal that the tightening cycle was over (late October).

At this point in the New Year, the view on the direction of rates remains clear, but the view on “when” and “by how much” has changed.  The view has adjusted to two, if not three fewer cuts this year.  And that adjustment in market expectations has been deliberately manipulated by the Fed.

The higher the borrowing cost, the stiffer the headwind (at the moment) for most companies not innovating on the leading edge of the next industrial revolution.

So, with that in mind, the interest rate market is now leaning in a direction that creates the opportunity for a positive surprise.  In this case, a positive surprise would be (more) weak inflation data, which could influence the Fed to lose its “patience.”

And we have two inflation data points coming over the next five days.  Tomorrow the Bureau of Labor Statistics will publish the revisions to its CPI seasonal adjustments.  These are adjustments that can change the CPI data for the past five years.

That’s a big deal — a big enough deal for both the Fed Chair and Fed governor (Waller) to recently emphasize it as something that could “change the picture on inflation.”  They both pointed to the adjustment last year that reflected hotter than previously reported inflation data.

So, clearing that hurdle tomorrow, with no adverse adjustments to the current inflation trajectory, would be a positive for rate cut outlook. 

And then we get the January CPI report next Tuesday.

We’ve looked at the below chart on the Fed’s New Financial Conditions Index over the past couple of months.  Let’s revisit this, and talk about how it relates to what the Fed did with “real interest rates” (Fed Funds rate adjusted for inflation) in the late 90s …

As we discussed in one of my notes last month, if we look back at moments when financial conditions were historically this tight (denoted in the chart above), every moment was soon followed with some form of Fed easing (either rate cuts, QE or, in the case of 2015-2016, removing projected rate hikes).

In the 1994-1995 period, the Fed continued raising rates into a low inflation, slow economic recovery.  It was a mistake.  Financial conditions were tight.  By July of ’95, the Fed did indeed start cutting rates (i.e. easing).  And in doing so, they set into motion a boom-time period for growth and stocks.

The economy went on to average 4.5% quarterly annualized growth through the end of the 90s.  And stocks put up five big, double-digit return years, averaging 26% per annum.

But as you can see in the next chart, the Fed kept real rates at historically high levels throughout this boom.  

So how did the economy and markets do so well, with the Fed holding real rates high (which is restrictive to economic output)?

We were in a technology revolution — rapid adoption of the internet.  Productivity was high.  Inflation was low.  The economy was booming, even with the Fed tinkering with interest rates around 5%.

So, with this late 90s period, we can see parallels to the current environment.

Could the Fed hold real rates here (at historically high levels), and still get a boom-time period, driven by the technology revolution of generative AI?

Growth solves a lot of problems.  But the U.S. debt/gdp has doubled since the late 90s.  And while the debt service/gbp is comparable to the late 90s period at the moment, it won’t be as they continue to refinance at high nominal rates. 

The Fed doesn’t have the luxury to sit around and watch for long.  They have to cut.  

The Fed Chair (Jay Powell) appeared last night in a sit down interview on 60 Minutes.

This type of mainstream media interview/Q&A session with the Fed Chair has historically been rare, though less rare in the post Global Financial Crisis era. The Fed Chair tends to talk economics and policy with economic and policy practitioners.  These types of Q&A’s are typically done in Congressional hearings, following Fed meetings, or at select economic conferences.

With that, these 60 Minutes interviews have clearly come at times, over the past 15 years, when the Fed has the desire to speak directly to the broader public.

Last night’s sit down with 60 Minutes was Powell’s fourth, in his five years as Fed Chair.  His predecessor, Ben Bernanke, also used the 60 Minutes platform to speak to the American people a couple of times.

What was the common theme in each of these interviews?

A crisis of confidence, or (at best) the vulnerability of confidence.

For Bernanke, back in 2009 and 2010, he was directing the Fed through the storm of the financial crisis, and he and the Fed were being destroyed in the media.  And that media tone was opening the door for global leaders to take shots at the Fed.

The Fed was trying to restore confidence, and it wasn’t going well.  So, Bernanke took to 60 minutes to speak directly to the people – to set the record straight.  He shot down the media criticism and said he was seeing signs of “green shoots” in the economy.  This first Bernanke interview (in March 2009) set the bottom in the stock market — and it turned the tide in global sentiment.

In late 2010, the Bernanke interview followed a bad jobs report that left confidence vulnerable, and left stocks vulnerable to undoing the progress of the previous year.  Bernanke’s attempt to assuage fears led to a 10% break higher in stocks, to new post-Lehman highs.

For Powell, his first sit down with 60 Minutes was in March of 2019.  We had just ended the week with a 4.4% plunge in Chinese stocks.  Powell appeared on 60 Minutes that Sunday night.  It was a response to the growing risks of a confidence shock (given the December 2018 stock market decline, Brexit drama and China/U.S. trade uncertainty).

It was an opportunity to tell the public that the economy is doing well, despite the media’s doom and gloom stories.  Stocks bounced and rallied 9% over the next month and half and went on to new record highs.

In May of 2020, Powell made another 60 Minutes appearance.

It came on the back of a very soft CPI number, which created chatter about negative interest rates and a deflationary spiral (this, despite the massive policy response to the lockdowns just months earlier).

Stocks went south.  Powell emerged.  By Monday morning, stocks were popping, continuing the sharp recovery (17% higher in just three weeks).

Powell appeared again, for a 60 Minutes sit down, in April of 2021.  Stocks had just finished the prior week on record highs (unlike prior 60 Minute appearances).

But a risk to confidence was lurking.  The threat of an inflation shock was building.  Ten-year Treasury yields had nearly doubled on the year, back to pre-pandemic levels (of around 1.7%).  CPI data was on the calendar for the coming week, and expectations were for another hot number.

The Fed’s concern at that time?  A stall in the momentum of the fragile economic recovery.

So, in that interview, Jay Powell assured the public that the Fed would not budge on its ultra-stimulative policy, until the recovery was “complete.”

The 60 Minutes effect worked, again.  Stocks went up.  Yields went down.  And to cement confidence that the Fed would keep the pedal-to-the-metal on the economic recovery, they introduced the word “transitory,” when describing inflation, later that month.

Now, Powell was back in the seat again last night for another interview (actually record last Thursday).

He had just finished the recent Fed meeting, where he implied they had the luxury of being patient with rates at these currently high and restrictive levels, because the economy is strong, the labor market is strong, and inflation is going their direction.

What’s the concern this time?  If the history of these interviews is our guide, it’s the threat of waning confidence.  In this case, waning confidence would mean maybe the Fed doesn’t have the luxury of being patient.

With that, the 60 Minutes interviewer told him he had “disappointed a lot of people on Wednesday.”