The market's inflation squeeze

Everyone knew that this month's US CPI number was going to be a shocker (and next month's even worse). And yet, and yet Mr Market has blossomed on the announcement and the DJIA is up triple digits as Guambat's digits try to hit the right keys at 2 o'clock in the morning.

Rising inflation, of course, is often fought with rising interest rates, which tend to hurt capital assets like stocks. So why is the stock market thumbing its collective nose at the inflation numbers?

The market "expected" 0.2 monthly core inflation (not a passively mild number at that), and got what it expected, but headline expectations of 0.5% monthly came in higher at 0.6%, which, for our purposes, might in some quarters be the makings of a runaway train.

And as Mr. "inflation ex-inflation" Barry Ritholtz points out, on a year over year basis, these figures show we are all being slugged quite bruisingly in our real world hip pocket, even if the virtual world at the core of US Central Bank inflation is remaining almost (at least by comparison) tame-ish.

Still, Mr. Market behaved so exuberantly that the Wall Street Journal was able to "print" the headline of a story on the online front page "Tame Core CPI Pleases Markets" (which linked to this story).

Guambat reckons that it was all just a trading set-up, because Mr. Market is usually better at upsetting apple-carts than providing a rational marketplace. Given that "everyone knew" the figures would be bad, and given that the end of the futures contract quarter is approaching next week, Guambat reckons this was all nothing much more than an easy short squeeze lay-up by the good sports jockeying trading screens.

And why -- rationally -- should Mr. Market be more concerned that core inflation is upwardly challenged when headline is not?

Consider what's rotten at the core. (Hint: "housing 'slump'" ring any bells?)

This from WSJ's Realtime Economics blog:

This reflects an expectation of continued significant deceleration in the [Owner’s Equivalent Rent] (which accounts for a little more than 30% of the core!) and residential rent categories as vacant properties are transitioned to the rental market. This anticipated deceleration in the key shelter category of the CPI (which accounts for about 40% of the core) should help to offset any spillover effects tied to higher food and energy prices. –David Greenlaw, Morgan Stanley

Right now, what has mitigated a much sharper rise in core prices, which by the way at 2.3% on an annualized basis is well above the implied target range at the Fed, is the muted rise in the housing component over the past few months. It is our assessment that over the remainder of the year that firms will reach a breaking point with respect to the amount of pain that can be absorbed vis-à-vis already razor thin profit margins and begin to pass along those costs. –Joseph Brusuelas, Merk Investments

When inflation expectations are “well-anchored” (that is, the public trusts the Fed), it is the Fed’s opinion on the inflation outlook that matters. When inflation expectations start to drift, then the Fed’s outlook is relevant, but it is actually the public’s view on the future course of prices that is paramount. Even if the Fed thinks inflation will be fine, if the public is ratcheting up their expectations, legitimately or not, the Fed has no choice but to respond. Right now, we are in the verbal jawboning phase of that process, and if that doesn’t work, then the Fed will have to hike rates whether they want to or not. –Stephen Stanley, RBS Greenwich Capital

And this from BugaBear Stephen Roach via FT via Barry:

Moreover, as the stunning surge of the US unemployment rate in May suggests, slowing economic growth in the industrial economies is likely to open up further slack in labour markets [caused or correlated, Guambat reckons, by cheap Asian labour], thereby putting downward cyclical pressure on [developed economy] wages over the next couple of years.

But there is a new threat to global inflation.... For developing Asia as a whole, consumer price index inflation hit 7.5 per cent in April 2008, close to a 9½-year high and more than double the 3.6 per cent pace of a year ago. But even the residual, or “core”, inflation rate in developing Asia surged to 3.8 per cent in April, more than double the 1.8 per cent pace of a year ago..."

Stratfor points out that food inflation is a problem of Biblical proportions:

What we are facing are dramatic increases in the prices of strategic commodities. A strategic commodity is one that is indispensable for a society in the short term.

Food is obviously the first strategic commodity, with grains constituting the foundation of all other foods save seafood. Oil is strategic but secondary. You can last without food for a few days, but you can manage without oil for a few weeks. Still, in the end, lack of either can wreck a society — or a life, for that matter.

The increase in oil prices has been orderly. You can buy all the gasoline you want if you are prepared to pay the price. Grain markets have been disorderly.

The Bible recounts, in the Book of Genesis, how Joseph became the grain broker for the Pharaoh, stockpiling grain in the seven good years in anticipation of the seven lean years. Joseph originated agribusiness on behalf of the Egyptian government. The Egyptian government had to protect the country against famine in order to avoid an uprising driven by hunger.

We are clearly moving into a lean period.

Guambat reckons Mr. Mainstreet will strike back at Mr. Wallstreet once this little trading squeeze is squozen.