Stock Market Warning: Is Deflation What Comes Next as the Fed Teases Rate Cuts?

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Wait… so now the Federal Reserve is going to cut interest rates in 2024?

I love how quickly narratives change. We went from thinking that the Fed would cut rates six times in 2024 to thinking that no rate cuts – and instead maybe a rate hike – were coming. Now, the narrative is that two rate cuts are on the table this year.

No one knows what comes next, and everyone is guessing. This is the reality of dealing with the unknowable tomorrow. The unknowable future. The one thing we can say with some degree of confidence is that we are still in the window where the fastest rate hike cycle in history can surprise market participants.

Last week’s CPI report shows that the cost of goods went unchanged in May. We haven’t seen something like that in two years. And the 12-month rate of inflation ticked lower than expected. A drop in gasoline prices is driving much of this, but investors in the stock and bond markets still reacted positively. Small-cap stocks particularly cheered the data. As you’ll recall, I’ve been sounding the alarm around small-cap behavior for the past year given how poorly they’ve performed. Any kind of rate cutting cycle provides a bit of a lifeline to these companies when they roll over their debt, hopefully into lower rates.

Warning: Brace for a Deflation Scare

However, the market is still at a tricky juncture. When we look at Treasury Inflation Protected Bonds (TIPS) relative to nominal Treasurys, we can clearly see that this ratio, as a measure of inflation expectations, is trading in a large sideways pattern. It does look like it wants to roll over here, suggesting disinflation could accelerate.

Inflation expectations continue to stay within a broad topping formation. pic.twitter.com/4Ddg6nhw4q

— Lead-Lag Publishing (@leadlaglive) June 12, 2024

I am growing more and more confident that the bear market for duration in the bond market is likely over, and that this in turn morphs into a credit crisis.

The market will continue to cheer disinflation until it becomes clear that credit spreads are starting to widen. Don’t ask me when this will happen – I’ve been horribly wrong in my timing thus far — but I still believe this is a likely outcome. Should the disinflation trend potentially create a deflation scare, then volatility would spike, and suddenly people will say the yield curve inversion was warning of recession correctly this whole time.

For the time being, enjoy the rally as breadth perhaps broadens. I’m not convinced it lasts that long.

On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

The Lead-Lag Report is provided by Lead-Lag Publishing, LLC. All opinions and views mentioned in this report constitute our judgments as of the date of writing and are subject to change at any time. Information within this material is not intended to be used as a primary basis for investment decisions and should also not be construed as advice meeting the particular investment needs of any individual investor. Trading signals produced by the Lead-Lag Report are independent of other services provided by Lead-Lag Publishing, LLC or its affiliates, and positioning of accounts under their management may differ. Please remember that investing involves risk, including loss of principal, and past performance may not be indicative of future results. Lead-Lag Publishing, LLC, its members, officers, directors and employees expressly disclaim all liability in respect to actions taken based on any or all of the information on this writing. Michael A. Gayed is the Publisher of The Lead-Lag Report, and Portfolio Manager at Tidal Financial Group, an investment management company specializing in ETF-focused research, investment strategies and services designed for financial advisors, RIAs, family offices and investment managers. InvestorPlace readers that are new subscribers to the The Lead-Lag Report can receive a 30% discount.

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