· Inflation and valuation worries hit stocks, but dip in tech is bought
· Dollar cannot capitalize on the troubles in equities
· US inflation data today could decide if selloff deepens or fades
Inflation scare broadens
There is no single explanation for the fear that has gripped Wall Street in recent sessions but there are several theories. Most of it seems linked to inflation and interest rate worries, considering that it's mostly tech and hyper-growth stocks that have imploded.
If you are an early-stage company whose stratospheric valuation is based on discounted cash flows ten years into the future, that valuation suddenly doesn't make much sense in a world of higher inflation and ultimately higher interest rates. Higher rates in the future mean that those discounted cash flows are worth less right now.
Another element that may have added fuel to the fire is option hedging by primary dealers. If many traders are shorting the market through options, the dealers that sold those options are then forced to hedge their exposure as markets fall and the strike price gets closer, by selling the index itself. This dynamic can amplify moves both on the way up, like last summer, and on the way down.
That said, the tech sector managed to turn the tables yesterday. The tech-heavy Nasdaq erased a sharp drop to close virtually unchanged, whereas the S&P 500 and the Dow Jones both fell substantially. It seems some investors went shopping to capitalize on the heavy discounts in tech and growth, even as the selloff started to infect other sectors.
Bigger picture still positive, FX market immune
The bleeding on Wall Street seems set to continue today, with futures pointing to another slightly lower open. Overall though, it is difficult to envision this gloom lasting very long.
Governments continue to do the heavy lifting through generous spending programs and the financial system is still overflowing with cheap central bank money. Even in an environment of higher inflation, there's no real alternative to stocks. Bonds are guaranteed to lose you money while commodity markets are too small and equally volatile.
The striking part is that the dollar has been unable to shine lately even as investors almost started to panic. This likely speaks to real US yields being depressed near record lows, as inflation expectations edge higher but the Fed insists that it won't turn the ship towards tighter policy. It's a toxic cocktail for the dollar.
It could be a tough summer for the reserve currency. Even if everything goes well with the American economy, the Federal Reserve is unlikely to discuss tapering until late August or September. With the same logic, it could be a great summer for gold. The endgame is still a more hawkish Fed, but it will probably take longer to get there.
Brace for inflation turbulence
As for today, the main event will be the release of the US CPI data for April. The headline rate is expected to skyrocket to 3.6% in annual terms. Normally such a print would be screaming for monetary policy normalization.
However, much of this acceleration comes down to soaring commodity prices, supply chain disruptions, and base effects after last year's plunge. It's not the healthy demand-driven inflation the Fed wants to see, so policymakers think it will fade before long.
Bearing in mind the nerves around inflation lately and the narrative around the Fed, any surprises in this data could have an oversized market impact. A higher-than-expected CPI print could sink equity markets but breathe some life back into the dollar, and vice versa.
