Inflation Surges, Rate Hike Inevitable Now? - Bezek's Daily Briefing

| About: iShares 20+ (TLT)


Inflation is moving higher.

Other economic measures are also showing renewed strength; a Fed hike is very likely now.

The US economic trajectory - and Trump's plans - have appealing points. But let's not lose sight of the risks.

Inflation continues to pick up. Data released this morning shows that several US inflation readings are at multi-year highs. The headline Consumer Price Index (CPI) surged 0.4% in October, on top of September's 0.3% increase.

However, much of these gains are due to a rebound in gasoline prices and a steady increase in the price of rent. Core inflation, which ignores energy and rents, rose by 0.1%, helped by a moderation in healthcare costs.

The Fed's measure of inflation hit 1.7% this month, reaching multi-year highs, but not yet reaching its 2% target. That said, the confluence of data suggests a December hike is highly probable. In fact, we should start thinking about the possibility of an additional hike in early 2017.

The bond market is certainly seeing red as economic indicators turn higher. The long Treasury bond (NYSEARCA:TLT) is off another percentage point today, hitting fresh new post-election lows.

This is since the economy is suddenly looking a good deal better. Atlanta's Fed branch raised its fourth-quarter GDP estimate solidly to 3.6%, which would be a big bump from last quarter's 2.9% growth rate.

Recent data out of the housing sector suggests that the rise in interest rates hasn't done anything to dent iss strength as of yet. The homebuilding sector (NYSEARCA:XHB) is up strongly today following strong October data. Housing starts are now at their strongest level since 2007.

And the labor market continues to firm up. First-time unemployment benefit applications just hit a new multi-decade low. It seems President-elect Trump will be inheriting an unexpectedly strong economy.

Will It Stay That Way?

Central banks have targeted higher inflation for a long time now. We can argue about whether or not this is a valid goal for monetary policy; however, it appears that, in the US anyway, the central bank is finally starting to achieve a modest victory on that policy goal.

In theory, this should be a positive. Higher inflation signals a stronger economy and encourages a higher velocity of money. Monetary velocity in the US has collapsed since the onset of the financial crisis:

Click to enlarge

There are various economic theories for why monetary velocity has continued to collapse since 2010. However, it's likely true that regardless of the cause, higher inflation will move some of this supposedly under-utilized capital back into the mainstream economy.

If people start to spend and (arguably more importantly) businesses invest in capital goods, it should cause a real pickup in economic growth. Trump inherits an economy starting to show some robust strength (against most people's predictions, including my own). And now he is offering strongly stimulatory measures on top of that. We should be setting up for a boom, right?

What could go wrong? First, interest rates that rise too far would jeopardize the benefits. Gradually rising inflation and interest rates are probably beneficial. A rapid spike, however, is certainly counterproductive.

Remember that other big-spending presidents, such as LBJ, inherited strong economies and ended up causing more harm than good with their policies. With the US national debt close to $20 trillion, a 1% rise in interest rates amounts to a $200 billion increase in debt service (though not all at once, of course).

To put that in perspective, $200 billion is equivalent to discretionary spending in 2015 on Veteran's Affairs, education and Medicare - not small potatoes. States and municipalities will also see rising interest burdens - there's no free lunch here.

And high interest rates (relative to other countries) will cause the US dollar to continue to spike. The Dollar Index (NYSEARCA:UUP) continues to soar:

Click to enlarge

This has two negative effects. First, US multinationals will have increasing troubles with every point the dollar rises. Earnings forecasts have to come down for 2017 - period - if the US dollar doesn't reverse trend soon.

Some sectors, such as certain smallcaps that we discussed recently, may miss out on the dollar problems. But in general, it's going to be a real problem for the stock market in particular, if not the broader economy.

On top of that, the strong dollar causes issues in emerging markets. Sure, developed Europe and Japan are probably thrilled that their currencies continue to decline. It helps their manufacturing sector.

However, in the emerging markets, the benefits of a weaker currency can be quickly outweighed by the negative effects that a falling currency causes. Capital flight takes hold as foreign investors panic. The marginal price of securities in countries such as India, Russia, or Brazil is often set by funds in New York and London rather than local investors.

This causes emerging markets to be forced to take actions that may be counterproductive in order to please foreign investors. Look at Mexico today - despite inflation being under control, the central bank felt compelled to hike its interest rate by 50 basis points to fight off currency speculators following Trump's victory.

A rational, self-interested central bank would keep rates on hold, or perhaps even leaning toward a cut, given that Trump will probably provoke a recession in Mexico in 2017. There's going to be a sharp fiscal retrenchment, and companies will be reluctant to hire new employees until the political uncertainty dies down. So the last thing you'd want to burden the economy with would be higher interest rates. When companies are already reluctant to engage in growth activities, jack up their cost of borrowing - that will help.

And the foreign capital owners weren't pleased, they wanted an even bigger hike - apparently half a point isn't a big enough statement. The Mexican peso dropped sharply following the decision, and Mexican stocks (NYSEARCA:EWW) sold off as well on the insufficiently vigorous hike.

Multiply that by a bunch of different emerging markets with submarining currencies, and you have the making of a global economic situation over the next year. Additionally, foreign high yield bonds (NYSEARCA:EMLC) became a hot investment category over the past year - the owners of these bonds will get to enjoy some grande losses as the cycle reverses itself. EMLC is already down 10% since Trump won - which represents two full years of yield lost. Oops.

None of this is intended to sound excessively negative. Trump's economic plans are interesting and may produce a significant boom within the US. Let's hope they do! But the approach doesn't come without risk. At some point, probably early in 2017, the stock market will likely reconsider whether Trump's new economics are an unmitigated good thing. And a Fed hike and threats of another will surely rein in enthusiasm as well. Enjoy the market's new all-time highs, but don't get complacent.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.