The Return Of The Inflation Dragon

Equity markets’ post-election euphoria hit a hard brake last week as reality reared its head and the laws of gravity took over. A trifecta of caution from Jay Powell, stubborn inflation readings, and a sobering reckoning with the costs and trade-offs of the incoming administration’s policy playbook left investors jittery.The inflation dragon is roaring back, and Wall Street is breaking a sweat. With tax cuts, tariffs, and fiscal expansion fueling the fire, price pressures are heating up—hotter than a bottle rocket’s backside on New Year’s Eve. Sentiment is flipping fast, and the street is bracing for potential impact.The post-election “Trump bump” lost some steam last week. The S&P 500 slid 2%, cooling off after a blistering 4.7% rally the week before, but the U.S. dollar showed it’s not ready to back down. Instead, it caught a second wind, fueled by market-moving forces.First, Federal Reserve Chair Jerome Powell’s cautious tone hinted that rate relief might not come as quickly as some had hoped. Second, the realization is sinking in: Trump’s tariff threats aren’t just tough talk—they’re shaping up to be a cornerstone of his trade policy. Third, the expected widening growth gap between the U.S. and other major economies sets the stage for the dollar to maintain pole position well into 2025.The dollar wasn’t the only heavyweight flexing its muscles this week—Treasuries joined the party as the sell-off roared back with fresh momentum. The spark? Jerome Powell delivered a dose of reality late Thursday, stating, “The economy is not sending any signals that we need to be in a hurry to lower rates.” Translation? The Fed isn’t rushing to cut, and inflation, while closer to the 2% target, isn’t there yet.October’s CPI and PPI data didn’t calm nerves either. Both landed perfectly on consensus—up 0.2% on the headline and 0.3% for core—but that was cold comfort. Annual CPI ticked to 2.6%, while core held steady at a still-sticky 3.3%. The three-month trend? A worrisome 3.6% annualized rate. Even worse, the PCE deflator is expected to trail by about a point, painting a picture far from rosy. When “as expected” reads more like “bad news,” you know the markets are bracing for impact.Retail sales didn’t help, holding firm in October with a 0.4% rise. This resilience gave bond bears all the ammunition they needed, reigniting the Treasury sell-off. By Friday morning, the 10-year yield surged to nearly 4.5%, hitting a five-month high. And here’s the kicker: the yield curve, inverted for what felt like an eternity, is now almost flat for the first time in over two years. The 10-year yield is neck-and-neck with 3-month T-bill rates, signalling that while the Fed plays the waiting game, the bond market is charging full steam ahead into a new, uncertain era.It’s not just the inflation dragon roaring back or the prospect of fewer Fed rate cuts sending U.S. yields skyward—fiscal concerns are also turning up the heat. President-elect Donald Trump, in true showman style, announced that Elon Musk and Vivek Ramaswamy will lead the newly minted Department of Government Efficiency, tasked with slashing costs and supposedly reining in the ballooning deficit. But let’s be real: trimming bureaucratic fat will not likely offset the towering cost of Trump’s proposed tax cuts.The October budget numbers didn’t exactly inspire confidence either, unveiling a jaw-dropping $257 billion deficit in the first month of the fiscal year. That’s the fiscal equivalent of tossing gasoline on an already raging fire. With interest payment, defence, Social Security, and healthcare swallowing the lion’s share of government spending, the room to maneuver is razor-thin. The bond market has taken note, with yields climbing higher as the weight of fiscal reality sets in. The main act could be even more dramatic if this is the prelude.In a move that cements the political landscape, Republicans officially hit the 218-seat threshold to retain control of the House, completing the much-touted red-wave trifecta. Emboldened by the clean sweep, President-elect Trump wasted no time rolling out a lineup of eyebrow-raising Cabinet nominations, among the headline grabbers: RFK Jr. at Health and Human Services, Matt Gaetz as Attorney General, and Tulsi Gabbard for Director of National Intelligence—a roster sure to spark lively debate.The Senate, now firmly under Republican control, named John Thune as majority leader, a choice reportedly not at the top of Trump’s wishlist. While the Senate could theoretically block some of these unconventional picks, it’s unclear if any will face serious resistance.The signal is loud and clear for markets: the incoming president is playing a game of take no prisoners, with an administration seemingly poised to deliver on campaign promises with full force. Investors should take note—not just seriously but literally—because this administration’s policy playbook could redefine expectations across the board. Buckle up.QUESTION PERIODOne of my sharpest clients, a former mentor and one of Bay Street’s fiercest bond traders in the 80’s and 90’s, hit me with a killer question: “Why haven’t inflation expectations gone ballistic yet?” Given the looming spectre of blanket U.S. tariffs and all the economic fireworks they could unleash, it’s a fair point. So why the market coolness? Let’s break it down.First, uncertainty is the market’s favourite sedative. Without a clear picture of Trump’s tariff play—whether it’s a light jab or a full-on haymaker—investors are holding back. Speculation only goes so far when the rules of the game are still being written.Second, the response playbook isn’t written either. How trading partners retaliate, how companies adjust supply chains, or how global markets brace for impact—these are wild cards that could temper the inflationary blast.And finally, the natural dampeners are kicking in. Oil prices are well below where many thought they’d be, taking the sting out of inflation. The U.S. dollar? It’s flexing its muscle, and that strength alone could smother the inflationary spark of any tariff hike stateside.Markets are notoriously slow to move on threats they can’t fully quantify, and inflation forecasts haven’t exactly set the world on fire. But do I think inflation risk is underpriced? You better believe it. When the smoke clears and the tariffs drop, expect this calm to explode into a frenzy of recalibration. The storm is out there—it’s just waiting for the right moment to hit.More By This Author:With Trump Back In The Driver’s Seat, Nothing Is Off-Limits
Friday Forex Follies: The Tip Of The Iceberg & Time To Join The Dollar Rally Wagon
Fed Chair Jerome Powell Delivered A Dose Of “Unvarnished Truth”