Inflation and its future path are probably the most important variables for financial markets at the moment. The latest CPI data came in well above expectations, and the Federal Reserve responded at its latest meeting by pivoting in an even more hawkish direction.
In essence, the FOMC seems to be looking at headline inflation and inflation expectations, which are driven in large part by gasoline prices, as its gauge to see whether or not its intended policy is having a sufficient enough impact on price levels.
This is despite the fact that the Fed's rate hikes, in concert with an economy that seems to be slowing on a cyclical basis, are already leading to weakness in many parts of the economy such as tech (NYSE: XLK), housing (NYSE: XHB), and retail (NYSE: XRT).
Until inflation peaks and heads lower, stocks will likely face a major headwind. However, inflation peaking could mark the low for stocks as it would likely signal relief for margins and allow the Fed to curb its hiking schedule.
At this point, everyone is familiar with what is driving inflation - energy prices and a broadening out of the inflation impulse into rents and other categories. This could get worse especially in the event of a geopolitical shock or inflation expectations and behavior becoming more entrenched.
However, there are some measures showing that inflation should follow the path of economic growth and weaken. A major reason is what we are seeing at the retail level, where companies have excess inventory and are going to have to mark down items to clear shelves. This should be a deflationary impulse.
This is also manifesting in lower shipping and trucking rates. The housing sector has also certainly cooled in terms of activity due to higher rates. Two more components of inflation that remain positive but well off their highest levels are wage growth and rents. Both are rapidly slowing and returning to a slower, more sustainable level of growth which bodes well for inflation readings.
For these reasons, it will be interesting to see how bonds react to see if the market also believes that inflation expectations become well-anchored. The first sign would be strength in longer-duration bonds even as stocks fall to new lows. This could be a signal to start to consider buying high-quality assets.