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Why Inflation Rates Will Not Run Wild And Yields May Head Lower
Rising inflation rates may not be as terrifying as some would make you think. In fact, the inflation rate has steadily been declining for over 30 years, and signs are suggesting that it is not likely to change anytime soon.
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Equities Lower
Two down days, now that is starting become a trend. The S&P 500 fell another 1 percent today, closing at our old friend 2,613. The gains beginning Friday topping out at 2,790 are gone, and we are back to where we started last week.
Powell is set to speak again tomorrow, and perhaps some of the late day sell-off and nervousness can be attributed to that? Perhaps. Rates on the 10-year declined to 2.86 percent, and the dollar index didn’t do a lot, the VIX managed to creep above 20 as well.
I’m trying to avoid having to start calling market direction every day because it isn’t easy. But I think this level around between 2690 and 2710 holds. It held quite nicely last week when a bunch of leadership stocks looked far worse.
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Current Valuation
It’s hard to call the market expensive at current levels when it is trading at 16.9 times 2019 earnings of $160.26, and 15.7 times 2019 operating earnings of $172.42. Equity prices are just way too cheap compared to bond yields. On average since 1961, 10-Year Treasury yields have traded at 2.2 times higher than S&P 500 Dividend Yields. With a standard deviation of 0.87, putting it in a range of 1.32 to 3.06. Currently, 10-year yields are trading at only 1.47 times the S&P 500 dividend yield, well below the mean.
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Forget About Inflation
It is interesting to see all the talk about inflation, but it may not be as wild as everyone fears. I know I wrote earlier in the year, CPI could climb to 3 percent, but let’s face a 3 percent inflation rate is nothing to tremble over. But my favorite reading to help me predict future inflation is the Velocity of MZM.
At its most basic form, the velocity of MZM is just a ratio, nominal GDP over the MZM money supply. That is it! Some people like to over-complicate; I don’t. I take it for what it is, a ratio. In its simplest form, every dollar created in 1980 created about $3.5 in GDP. Today every dollar produced in MZM generates only $1.3 in GDP. As you can see in the chart below, the Velocity of MZM has traced 10-year treasury yield almost perfectly. 
So based on this type of analysis, there two ways to stoke inflation, grow the economy at a faster pace and slow the amount of money we print.
The chart is telling us that each dollar we create is less productive than it was in the past. Each dollar generated today, produces fewer goods and services, hence low inflation.
The current trend in the velocity of MZM would suggest to me that any rise we see in inflation this year, so likely to be minimal, and short-term.
To be truthful, with the current GDP reading for the fourth quarter at only 2.5 percent, GDPNow tracking the first-quarter at just 2.6 percent, and the Velocity of MZM at 1.3, the Fed would have to be nuts to raise rates three times let alone four times in 2018. If they want inflation to come back, they should leave rates alone, and let the GDP grow on its own.
Unless something changes meaningfully, then it would suggest rates are heading lower, not higher from here.
Night!
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Tags: #sp500 #inflation #yields #velocity #money #mzm