Premium: The world is ending, oh hang on

These past few months have been tough.

There's been no clarity whatsoever.

Plenty of noise about inflation though, and this is where we see a fantastic disappointment trade setting up.

The main reason markets care about inflation is because of the Fed response.

The argument?

Too much inflation leads to the Fed tapering QE & hiking sooner and/or faster.

Simplifying, liquidity is withdrawn, the credit tightening cycle begins and the party is over.

Of the FOMC members that matter, none are advocating tapering any time soon.

Talking about, thinking about, thinking about talking about... but not doing!

It's too soon.

The new framework shifted to Average Inflation Targeting.

Powell & the gang have been crystal clear on this.

The communication in advance of high inflation readings has been excellent too (base effects, bottlenecks & transitory).

Everyone knows they will ignore these prints.  

The bond market has been ignoring it too, and 5y breakeven inflation rates  (the market based expectation of inflation over 5 years) have been falling for the past couple of months...

The extremes of the base effects will be seen in the April & May data...

And then what?

After Thursdays inflation data for May (expected at 4.7%) gets the inflationistas all excited, that's it...

Peak inflation.

It's all downhill from here...

Inflation fades into the background...

Economic 'overheating' fears are overblown

No reason to tighten policy.

How about employment?

This is now the Fed's primary focus: they're aiming for full employment.

How's that going?

No matter how you measure it, unemployment is still far too high to qualify for 'substantial progress' towards that full employment target.

Half of the U.S. states are beginning to withdraw the enhanced unemployment benefits.

The other half will expire as scheduled on September 6th...

No mad rush back to work...

Adding ~500k jobs (on average) each month this year is pretty good going...

BUT employment is still 7.6 million below pre-pandemic levels.

9.3 million people were classified as unemployed last month.

What would qualify as substantial progress towards the Fed's goal of maximum employment?

3 million below the pre-pandemic level?

At the current rate, even that would be 8/9 months away...

Even if there is a big rush back to work, it's unlikely to be before September when kids return to school and the UI expires.

The Fed have been very explicit: Policy is now outcome-driven, not forecast-driven.

They will react to the data rather than pre-empt it.

On top of that, which option is least bad for the Fed?

Say inflation is a little stickier than they would like, they have the tools to deal with it

If they start tightening policy prematurely, it would cut off the labour market recovery at the knees, which clearly isn't in line with their longer-term goals.

Then there's the RRP facility, and everyone misunderstanding it as a long-term liquidity reduction measure.

In fact, reducing bank reserves would allow banks to add to balance sheets in greater size...

The longer term trend is regularly ignored amidst shorter term shocks.

These shocks represent tail risk occurrences and are generally absent from the broader trend...

e.g. the oil crisis in the '70s DID lead to inflation, but that didn't last.

It was a supply shock which later subsided.

How many times have bond yields spiked higher in anticipation of inflation?

This many...  👇👇👇👇👇

What else do we currently see?

Surely that's a good enough reason to just blindly long the S&P, no questions asked?

OK, what else?

Excitable inflationistas joyously claiming that it really IS different this time, they're finally being proven right and doing their best impressions of this guy 👇

Remember the big VIX call spread buyer?

Looks like that 25/40 range won't be met.

The VIX is back around pre-Covid levels...

Volatility is trending lower

Bonds 👇

FX 👇

So, we're looking at an environment where traders may have got ahead of themselves on inflation causing the Fed to taper soon...

Jobs growth is strong... but not strong enough to warrant any conviction that the Fed will announce the taper at Jackson Hole in August 👇

Have we gone full-circle?

Low rates, cheap money still on tap... Inflation fears in the rear-view mirror...

Yield-hungry investors fighting to find a home for their capital...

Sound familiar?

Where's all of that cash going to go?

Into 10Y treasuries at -0.82% real yield, or the crappiest junk bonds with zero risk premium left in them?

Nope, we go back to the previous trend of lowish growth with easy monetary policy.

And what was THE trade of that regime?

Long equities.

We still have the easiest monetary policy EVER...

All of the reasons for the Fed to take away the punchbowl are being pushed further into the future...

Where else are investors going to put their cash?

There are two near-term risk events to navigate.

U.S. CPI on Thursday.

Print below expectations, inflation risk can be brushed off entirely and risk assets should get a boost...  

If it prints above expectations, inflation has likely peaked anyway, but maybe risk will be a little more cautious...

Until the FOMC next week.

If the Fed stay on script and the dots don't shift too hawkish (and why would they?) then it should be a flashing green light for risk assets...