Inflation, Rising Interest Rates And The S&P 500

I find it incredible that some are still predicting possible deflation when everywhere there is inflation. It seemed strange months ago when I was predicting inflation that many “respected” economists didn’t see inflation coming. Nonetheless, it is here and it is here to stay.

It is here to stay because the money is already out there to drive it; it can’t be pulled back without cratering the economy by crushing hugely indebted businesses and governments. The supply chain problem, driven by two years of destocking to generate cash, is not going away until the parties involved get restocked; government needs inflation to reset their finances.

You can add to that list too if you want, but those simple reasons are enough for me.

Nonetheless, governments won’t let runaway inflation happen or at least they will try to contain inflation and they will do that by quantitative tightening, the opposite of quantitative easing (QE). The process will start by draining the $1.7 trillion of surplus cash lodged with the Federal Reserve by the financial system that has had it supplied by the Federal Reserve and cannot or will not find a place to put it to work. On the face of it this can be drained and burnt because no one “wants” or needs it. It can be magicked away in a reverse of the process that made it appear in the first place and no one will be affected. Perhaps no one will be affected. If that money is an inert island of cash, then the Fed can pull it out and burn it and nothing bad will happen. If, however, it is just a tip of an iceberg you can invent your own metaphors for what might happen when it is removed.

So the call is: if this inert money is burnt by QT, is that a nice null event that lowers the Federal Reserve’s balance sheet or is this money actually connected to the whole system and will actually yank $1.7 trillion out of the system in a way that causes a chain reaction of tightening? If this was to be true, would it be a gentle tug to the global economy or the shove that sets the dominos tumbling?

If you can feel a sudden doom scrolling session coming on, there is a way to monitor the effect, one way or another.

Money flows like honey. Take the lid off it and pretty soon you and everything is covered in a sticky film of it. So when you QE in the U.S., the money doesn’t stay local, if flows through the system balancing risk and yield. It goes global pretty fast. When you QT it comes home but it comes home from the periphery first because that’s the riskiest place and the first to be drained. It’s the sketchy places that get the full blast of tightening, so you can expect to hear cries of financial and economic misery in faraway sketchy places first. By watching markets outside the U.S. you will be able to get a handle on the effect of Federal Reserve QT before the process hits home.

Where to look? Germany and the DAX. Here is the chart:

The S&P 500 has all sorts of noisy factors that can hide the trend, but look away and at the DAX and you have another guide.

The S&P 500 is now riddled with noise:

However, it is clear the trend is over, but the increase in noise is just an indication of uncertainty about what comes next.

If the DAX keeps chugging along it will be a strong indicator that the wheels are going to stay on, but if the DAX suddenly breaks down on its own, it will be a strong signal that tightening is going to thump the stock market in the U.S.

Personally I’m already risk off and if QT isn’t done just right we could easily see a 25% drop from the all-time high. However, I don’t think that’s in the plan of the central planners, but at some point it’s inevitable that those tightrope walkers will blunder and that will show first in the periphery of the global economy, even ones as robust as Germany. It is after all obvious that the DAX and the S&P 500 are joined at the hip and it is the Fed not the ECB that sets the stock markets agenda.