Otherwise, how do you know what the market will do next?

Outlook: The calendar includes Industrial Production and the Empire State Manufacturing Index (forecast at -5 from -1.5). Later in the week we get permits and housing starts, existing home sales, the Treasury’s capital flow report, Philly Fed, unemployment insurance claims, etc., along with the numbers for inflation and the ZEW outside Europe. Information overload, as usual.

It’s hard to ignore Friday’s GDPNow update from the Atlanta Fed – a small drop from 2.9% to 2.8% for the third quarter (and based on a small drop in real spending growth We’re getting another on Wednesday Notice how choppy the chart is – way Also the current reading above and outside the most likely range of the blue shade so we should probably get expect a drop anytime now.

This raises the question of whether interest rates can or should be based on or at least correlated with economic growth. We’re pretty sure rates shouldn’t be zero or negative (ever), but what’s the relationship? Conventional economics indicates that a rate hike is inversely correlated to growth and “should” suppress it. But just as low and negative real rates do not necessarily stimulate new growth (only asset bubbles), historical data over long periods and after financial crises does not confirm this. In other words, current conventional thinking is (ahem) wrong. This means that short-term inflation targeting is also bad central bank policy, and not just because of our favorite bugaboo, Lag.

Just for fun, check out a chart from The Economist last week showing the 12-year average of GDP-weighted bond yields heading relentlessly toward zero over the centuries. It’s hard to know if The Economist has its tongue in cheek showing this graph, even though the economists behind it seem pretty serious. Alternative economists would say that this chart misses the point and that the weighting by GDP is what ruins it. How about a graph showing that real rates and GDP don’t have a strong correlation? There is a correlation, but it’s weak and inconsistent, and some economists manipulate the data to adjust lags and other changes to make the lags disappear and make the model look accurate. The BIS has spent a decade complaining about precisely this point where zero and negative rates have failed to spur growth.

The point here is not to quarrel with conventional economics or embrace second-tier alternatives, but to point out that while bond vigilantes are preoccupied with short-term self-interest, there is a growing framework of “correct target” vigilantes who see the Fed and other central banks as too unconcerned about growth and too concerned about inflation. The result is the same: the Fed will exceed its limits in its aggressive tightening.

The overshoot isn’t exactly what the latest WSJ poll says, but it does indicate that the likelihood of a recession in the next 12 months is 63%, down from 49% in the July survey. The WSJ panel of economists expects GDP to contract 0.1% in the first quarter and 0.1% in the second quarter. Interestingly, the FT reports comments from several major US banks and they see no flaws in their operations.

Bottom line, again, it seems clear that the dollar can rise alongside rising yields and an aggressive Fed, with two 75 basis point hikes now expected before Christmas. That’s not to say we won’t get profit taking and/or overdraft coverage in other currencies, as we are currently seeing with the British pound. We could also see some buoyancy in emerging markets now that risk may return now that the UK has seemingly repelled a crisis.

Treat: The price action in the stock market last Thursday, which could in no way be attributed to the inflation report, was oddly abnormal. The stock market “should have” fallen on the news. Instead, it rallied more than 5% and closed up more than 2.5%. We may be getting something similar today – a rally in equities just as the WSJ’s panel of economists predicts the likelihood of a recession over 50% for the first time.

This is one of those times when trying to make a cause and effect explanation falls flat and raises the question of how much fresh news and/or economic reality affects stock prices. The answer is that most news-based explanations are BS in the first place, a scary thought. Otherwise, how do you know what the market will do next? Well, graphics. This time, the S&P in particular was hitting what looked like a cyclical low. Those who bought while selling were exhausted were rewarded. The secret is to see where the sellers are running out of steam.


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